UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the year ended December 31, 2002
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 0-220-20
CASTELLE
(Exact name of Registrant as specified in its charter)
California 77-0164056
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
855 Jarvis Drive, Suite 100, Morgan Hill, California 95037
(Address of principal executive offices, including zip code)
(408) 852-8000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
No Par Value
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No __
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in any amendment to this Form 10-K or in
definitive proxy or information statements incorporated by reference in Part III
of the From 10-K. ___
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes No |X|
--- -----
The approximate aggregate market value of the common stock held by
non-affiliates of the Registrant, based upon the last sale price of the common
stock reported on the Nasdaq SmallCap Market on June 28, 2002 was $3,093,580.
The number of shares of common stock outstanding as March 7, 2003 was 3,160,947.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III of this Form 10-K will be incorporated by
reference from certain portions of Castelle's proxy statement relating to its
2002 Annual Meeting of Shareholders to be filed with the SEC or will be provided
in an amendment to this Form 10-K to be filed with the SEC no later than April
30, 2003.
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that are based on our current expectations
about our company and our industry. All of our forward-looking statements
involve risks and uncertainties. The Company's actual results could differ
significantly from our expectations and from the results expressed in or implied
by these forward-looking statements. Factors that might cause such a difference
include, but are not limited to, those discussed elsewhere in this Annual Report
on Form 10-K. We urge you to consider these cautionary statements carefully in
evaluating our forward-looking statements. Except as required by law, we
undertake no obligation to publicly update any forward-looking statements to
reflect subsequent events and circumstances. Important factors that may cause
results to differ from expectations include those discussed in Risk Factors
beginning on page 26 in this document.
PART I
ITEM 1. BUSINESS
The following summary should be read in conjunction with, and is
qualified in its entirety by, the more detailed information and Consolidated
Financial Statements and Notes thereto appearing elsewhere in this Annual Report
on Form 10-K.
OVERVIEW
Castelle was incorporated in California in 1987, and its principal
offices are located at 855 Jarvis Drive, Suite 100, Morgan Hill, California
95037. Unless the context otherwise requires, references in this Form 10-K to
"we," "us," or the "Company" refer to Castelle. The Company's telephone number
is (408) 852-8000. Castelle(R), LANpress(R) and JetPress(R) are registered
trademarks and InfoPressTM is a trademark of the Company. This Annual Report on
Form 10-K includes trademarks and trade names of other companies.
Castelle develops, manufactures, markets and supports office
automation systems that allow organizations to implement faxing and printing
over local area networks and the Internet. A market leader in fax solutions for
small to medium sized workgroups, Castelle's FaxPress fax servers provide a
simple way to integrate fax with email, desktop and back-end applications. The
Company also provides LANpress print servers, which enable users to locate
printers anywhere on the network, and the InfoPress information-on-demand
software suite. Castelle products are designed to be easy to use and maintain,
and provide an economical way for companies to share resources over their
networks.
The Company's products have historically centered on fax and print
servers and related technologies. Beginning in 1997, the Company's revenues
declined as competition increased, primarily with the print server products in
the Asia Pacific region, while at the same time the Internet and other
networking technologies advanced. As a result, the Company experienced annual
operating losses during 1997 through 1999. During the past four years,
management has redirected the Company's efforts to focus on server appliances
and on development efforts to integrate existing and future products with the
Internet and emerging networking technologies. Through the introduction of
enhanced fax automation products that generate higher gross profits,
restructuring and cost reductions, the Company was able to report operating
profits in the fourth quarter of 1999 and in each of the four quarters of 2000.
In 2000, the Company recorded a profit of $732,000 with sales at $14.8 million.
The Company incurred a loss of $591,000 in 2001 with sales of $9.4 million,
resulting from a decrease in demand for our products due in
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part to the slowness of the economy. The Company's sales and profitability
rebounded beginning in the third quarter of 2001, and the Company recorded a
profit of $659,000 in 2002 with sales at $9.8 million.
Industry Background
In the mid-1980s, organizations began to interconnect personal
computers into local area networks (known as "LANs") in order to allow work
groups to share files, peripherals such as printers, and other specialized
applications. As LANs have proliferated throughout organizations and
client/server architectures have gained acceptance, they have become
increasingly complex and the applications operating on computer networks have
become more critical to the success of the business enterprise. The further
proliferation of the Internet and Intranets and popularity of electronic
communications expanded the role of LANs as a means to provide common access to
the Internet, email and other office automation applications. Installation,
maintenance and administration of LAN equipment required a staff of highly
skilled professionals. The costs associated with LANs and related equipment,
server-class hardware, specialized software, network integration and support
services are significant and typically affordable only by larger organizations.
Many businesses were not able to afford office automation applications beyond
basic email, such as integrating fax technology into the network. This has
created the opportunity for specialized networking equipment that would perform
a single application very well, known in the industry as a "server appliance".
It is similar to using a toaster instead of an oven, it does a specific job
better and it costs less. A server appliance is an integrated hardware and
software product designed to reduce the complexity and cost for a specific
server-based application. Internet routers, email servers, remote access
servers, communication servers, fax servers and print servers are examples of
server appliances used by businesses today.
The Company pioneered server appliances, establishing a benchmark for
"plug and play" and ease of use with its fax and print server product families.
Fax Office Automation Products: Fax machines have become a basic method
of doing business worldwide. Fax is ubiquitous in business; many homes even have
fax machines. While computers have automated many business applications, faxing
remains as a basic method of business communication. We believe fax is here to
stay, just as the computer in its quest for the paperless society has not
replaced paper. Fax servers integrate legacy fax business methods into LANs and
the Internet to improve office productivity. Fax servers also provide the
opportunity for new business applications to be developed to take advantage of
the inherent strength and prevalence of fax machines. Every business in the
world has a fax machine which can be used as a remote printer to receive
information directly from a corporate information system via a fax server.
Sending purchase orders, invoices, order confirmations, etc. directly to a fax
machine, as compared to using the mail, is a growing segment of the fax server
market.
The increasing popularity of email and the Internet has provided a
boost to all types of electronic communications as many users and organizations
become more comfortable and accustomed to their use. To further simplify and
improve inter- and intra-organizational communications, corporate Management
Information Services departments are looking for ways to integrate different
types of messaging into a unified messaging environment. Fax remains one of the
key business communication tools and is one of the essential components of the
corporate messaging environment. In corporate communication infrastructures, fax
is being integrated into email. To facilitate this capability companies install
email-integrated fax server systems.
Fax servers allow users to send and receive faxes as easily as emails,
using the same email application for both types of messages. A fax server can
sort incoming faxes directly and deliver them electronically and confidentially
to the electronic mailboxes of the intended recipients. A fax server can also be
used as an independent network shared system in environments that require high
volume incoming
2
and outgoing faxes. Users are able to send and receive faxes directly from their
computers or workstations, eliminating the need to print a document, take it to
a stand-alone fax machine and wait for its transmission. Fax servers can help
reduce fax transmission costs by sending non-urgent faxes at "off-peak"
telephone rates and by utilizing fax over the Internet technology.
Many fax servers are implemented using complex software that requires a
Windows or UNIX network operating system, a server-class computer, and
specialized expensive fax modems. Castelle's fax server, FaxPress, is a
self-contained unit with all the necessary hardware and software to integrate
fax into network, desktop, email and back-end applications. As a server
appliance, it is designed to be easy to use and maintain and we believe that it
is more economical than other solutions.
Automated delivery of information is another popular application of fax
technology. Fax-on-demand is the ability to use a touch-tone phone and a fax
machine to request and receive copies of documents on demand. Although there are
a wide variety of applications installed, the two most common applications are
customer support and literature fulfillment applications. The largest industry
using fax-on-demand is the high-technology sector, with applications also
installed in travel, government, newspapers, manufacturing and non-profit
organizations. Essentially, any company with information to disseminate publicly
is a potential information-on-demand customer. Castelle's InfoPress product line
provides a comprehensive solution for automated information delivery via fax and
email.
Print Servers: The sharing of printers, which is a basic benefit of a
LAN, has traditionally been provided by connecting a printer either to a network
file server or to a dedicated personal computer on the network. However, direct
connection to the file server has several disadvantages, including the risk of
the file server being overburdened by the processing required to print large or
graphically complex files, lower print transfer speeds and location
inflexibility. Similarly, printer connection to a dedicated personal computer,
while providing better location flexibility, is more costly and offers
substantially lower print file transfer speed than a dedicated print server can
provide. A print server directly connects one or more printers to a LAN,
providing a cost-effective, high-speed solution to the demand for shared print
resources on a LAN. In addition to providing location flexibility and
convenience, print servers improve network performance by relieving the burden
on the file server. Furthermore, print servers enable users to access essential
information about the status of the printer and their print files and to select
their desired printer configuration.
Server appliances, such as communications/messaging servers and print
servers, have emerged and gained market acceptance due to their ability to
significantly reduce complexity and cost associated with the installation and
maintenance of networking systems. These appliances also make the complex
functionality of Internet and Intranet communications available and affordable
to many smaller businesses. As MIS professionals in larger organizations and
business owners of smaller enterprises continue to recognize the benefits of
server appliances to provide such critical functionality as Internet and
Intranet communications, remote access, scanning, faxing, electronic mail and
related functions, the Company believes that the demand for such network systems
will increase.
Castelle Strategy
The Company's objective is to be a leading worldwide supplier of server
appliances providing office automation solutions and other shared services. The
Company pioneered server appliances, establishing a benchmark for "plug and
play" and ease of use with its fax and print server product families. The
Company's products are installed in many Fortune 1000 firms, and in small and
medium sized businesses worldwide. The Company is now applying its proven
technology to the office, integrating desktop fax automation, email, Internet
connectivity, print and other shared services.
3
Focus on Server Appliances: The Company focuses exclusively on
providing innovative, reliable, easy-to-use network products. Since its
inception, the Company has focused on developing networking products that
utilize advanced software to tightly integrate proprietary hardware systems with
standard computing platforms. As a result, the Company believes it has developed
a high level of expertise in networking, software development, hardware design
and telephony technology. The Company plans to capitalize on these attributes by
continuing to focus on providing network enhancement products that enable users
to communicate more effectively.
Focus on Application Solutions and Communications: The Company focuses
on developing application solutions for inter and intra-company communications.
The Company believes that its focus on application servers rather than on
infrastructure systems enables the Company to offer products that bring higher
value services to customers and provide a higher margin to the Company.
Expand Product Line: The Company is leveraging its expertise in server
appliances to offer new easy-to-use, cost-effective solutions. The Company
continues to expand both its fax and print server products and apply its proven
technology to other areas.
Focus on E-commerce and Other High Volume Distribution Channels: The
Company has established a two-tier domestic and international distribution
network of leading national and regional network product distributors and
resellers including Ingram Micro and Tech Data. The Company's products are well
suited for sale by e-commerce vendors and the Company has been successful
working with leading resellers such as CDW and Insight. The Company is focused
on maintaining and strengthening its current distribution network in North
America, Europe and Asia-Pacific regions.
Leverage Strategic Relationships: The Company augments its product
offerings by establishing relationships with companies able to provide products
in areas outside of the Company's core technical competencies or in instances
where internal development of such products is not cost-effective. The Company
also establishes relationships with numerous leaders in hardware and software
technology to enable it to keep abreast of, and respond quickly to,
technological changes that may affect the network enhancement market.
Products
The Company develops and markets a range of server appliance products
that enhance network productivity, performance and functionality. The Company's
current products are grouped into two areas: fax server products, including a
range of software enhancements, and print servers.
Fax Server Products: The Company offers the FaxPress family of
email-integrated fax server appliances. The Company positions the FaxPress as
the easiest way to add faxing to a company's network and integrate fax with
email. FaxPress allows network users to send, receive, route, print, store, edit
and retrieve fax transmissions from their own personal computers on a local area
network. FaxPress can be integrated into an email system creating a unified
fax/email messaging environment. FaxPress enables users to transmit documents
directly to a fax device as easily as if they were printing to a laser printer
or sending an email message. The product also provides network administration
features like control, monitoring, logging or configuration. The Company's fax
server products are designed to comply with current regulatory standards in the
United States, Europe and the Pacific Rim. During 2002, 2001, and 2000, fax
products represented 95%, 91% and 86%, respectively, of total net sales.
Key features of the FaxPress products (configured with its current
software versions) include:
4
o Easy Installation and maintenance: FaxPress is a fax server
appliance that is packaged with all necessary hardware and
software. The hardware system is a small box with an
integrated 10/100 Base-T Ethernet interface and one to eight
intelligent fax modems. FaxPress includes all required system
and client software.
o Support for popular network operating environments: FaxPress
operates in any local area network based on Microsoft Windows
98, ME and 2000; Windows NT/XP, and NT Terminal Server; Novell
NetWare; or Linux servers.
o Ability to create a unified fax/email messaging environment:
FaxPress has the ability to integrate fax into a corporate
email system, allowing users to send and receive faxes in the
same manner as emails. FaxPress supports Microsoft
Exchange/Outlook, Lotus Notes, Novell GroupWise, Netscape and
other SMTP compatible email systems. Castelle's unique Outlook
Direct interface offloads fax processing from MS Exchange
Server while maintaining tight integration with the Outlook
client.
o Integration with many popular accounting and Customer
Relationship Management applications: FaxPress is available
with the Reform-for-FaxPress software package from FabSoft
that allows users to send faxes from many popular accounting,
financial and payroll systems including Oracle, SAP,
PeopleSoft, Great Plains, ACCPAC, and Macola. Reform can
support any application that supports form printing.
o Ability to send faxes from many applications: Easy faxing from
within any Windows, Windows 95/98 and Windows NT/2000/XP
application such as Microsoft Office and Lotus Smart Suite.
o Electronic delivery of faxes to desktops: FaxPress supports
several methods to deliver incoming faxes direct to the email
or fax inbox of the intended recipient. Such methods include
Direct Inward Dialing, Dual Tone Multifrequency, T.30
sub-addressing, and line routing.
o Internet faxing capabilities reduce transmission costs:
FaxPress enables users to connect several units via the
Internet or the Intranet to form a private Fax-over-IP network
that can significantly reduce the cost of fax transmissions.
o Integration into custom applications: The Company provides a
software development kit that allows programmers to integrate
faxing functions into their current applications or to create
new customized applications that use the FaxPress server.
o Software Options: The Company offers a range of value-added
software options that increase the functionality of Castelle's
FaxPress systems and enables the FaxPress to address
specialized applications as mentioned above. Software upgrades
and options are available to the installed base of FaxPress
units at prices ranging from $495 to $995.
The Company offers a family of FaxPress fax server systems ranging from
entry-level products targeted for small businesses with fewer than 50 users to
high-end fax solutions capable of supporting enterprise-wide installations. The
suggested U.S. list prices for FaxPress fax server products range from $1,495 to
$9,995. Server pricing is based on hardware model, with no per-user costs. The
FaxPress 2500, 5000 and 7000 families come with the FaxPress 7.0 network fax
software that adds integration with popular email packages, and many advanced
fax management and integration features. FaxPress 7.0 Email Integration is not
included on FaxPress Small Business Edition ("SBE"). The following table
summarizes the Company's FaxPress system products:
5
---------------------------------
Network Environment
--------------------------------------------------------------------------------------------------
Number of NetWare Windows
Modems Email Network 3.x, 4.x, 5.x NT/2000/XP
Product Model Integration Topology (IPX) (IPX,IP)
--------------------------------------------------------------------------------------------------
FaxPress SBE 1 Not included Ethernet |X| |X|
FaxPress 2500 2 |X| Ethernet |X| |X|
FaxPress 5000 2, 4 or 8 |X| Ethernet |X| |X|
FaxPress 7000 8 |X| Ethernet |X| |X|
FaxPress 7500 8 |X| Ethernet |X| |X|
--------------------------------------------------------------------------------------------------
Information-on-demand systems: InfoPress software enables the access of
information via any touch-tone phone and a fax machine and allows the
dissemination of information via "broadcasting" to a select database of fax
numbers. InfoPress allows companies to use one source of documents in a Castelle
document library and to automatically publish the documents using either the
fax-on-demand and/or email-on-demand methods.
Castelle's InfoPress is a software product designed to operate on
Microsoft Windows NT/2000/XP platforms. The system utilizes voice and fax
processing hardware, as well as telephone system interface (analog or T1)
hardware with as few as two and as many as 288 ports that are actually deployed
at a customer site.
o Fax-on-Demand: Fax-on-demand allows a user to request and
receive information on demand by dialing a telephone number.
The user interacts with a series of voice prompts to select
specific documents, by simply using the telephone keypad, and
requesting delivery of these documents to a fax number.
o Email-on-Demand: Email-on-demand allows a user to request and
receive information on demand by using email. Auto-reply email
exists today, but is limited to receiving one document,
usually in text format. The main benefit of email-on-demand is
the ability to share the document library with fax-on-demand.
o Web Integration: InfoPress supports Web HTML documents in the
document library. The documents are automatically rendered
into a fax document when required.
Print Servers: Printer sharing continues to be one of the important
benefits of computer networking. Print servers are the most efficient and
economical way of sharing printers on networks. While demand for print servers
in various sizes of businesses continues to grow, the market is very
competitive. The Company has been involved in the print server business for more
than ten years. After continuous improvements on the cost and feature set,
Castelle's LANpress has become a well-received print server product line. Our
latest print server models incorporate a RISC microprocessor, Fast Ethernet,
Windows, Internet Printing and many other attractive new features. Castelle's
LANpress JR is the world's smallest print server commercially available today.
It's similar in size to that of a standard printer cable connector. The
suggested U.S. list price for LANpress print servers ranges from $149 to $345.
During 2002, 2001 and 2000, print server products represented 5%, 9% and 14%,
respectively, of total net sales.
6
The following table summarizes the Company's line of LANpress external
print servers:
-------------------------------------------------
| Network Environment |
---------------------------------------------------------------------------------------------------------------------
Ethernet Windows Flash
NetWare
Network 3.x, 95/ 98/ Apple Upgrade Internet
Product Configuration Interface 4.x, 5.x UNIX TCP/IP NT/2000/XP Ethertalk Capability Printing
----------------------------------------------------------------------------------------------------------------------
LANpress JR 10/100 MP (1) 10/100 |X| |X| |X| |X| |X| |X|
LANpress 3P/100 10/100 |X| |X| |X| |X| |X| |X|
LANpress Jr. MP (2) 10 |X| |X| |X| |X| |X| |X|
LANpress 2000 2+1 MP (3) 10/100 |X| |X| |X| |X| |X| |X|
----------------------------------------------------------------------------------------------------------------------
(1)One Centronics parallel port
(2)Connects directly to port on Printer
(3)Numbers refer to the number of parallel
and serial port connections, respectively.
Research and Product Development
The Company has invested substantially in research and product
development since inception. The Company believes its future performance will
depend in large part on its ability to enhance its current products, to expand
its product offerings, to maintain technological competitiveness and meet an
expanding range of customer requirements.
Castelle continues to invest in enhancing its server appliance product
lines by developing new versions of client and server software and server
hardware. The product feature set is driven by the increasing complexity of user
needs. The changing corporate communications/messaging environment and
increasing demand for easy-to-use networking systems define these needs. The
development efforts are focused on enhancing functionality of existing products
and developing other systems to expand our product offerings. The Company's
development efforts are focusing on high value applications, while relying on
our partners to provide basic functionality for some of our product lines.
In 2002, the Company developed and released version 7.0 of its FaxPress
software. The new release of FaxPress 7.0 Network Fax Software offers a new
level of email integration, expanded operating environments and fax automation.
It includes a new gateway for IBM Lotus Notes email integration, improved
integration with Microsoft Exchange, enhanced Windows XP and Citrix MetaFrame XP
support, improved Novell client support, production faxing and fax automation
made easy.
The current FaxPress fax server product line is continuously being
enhanced to offer greater integration into corporate networking environments.
There can be no assurance that the Company will be successful in
developing and marketing the new software and hardware product versions or in
identifying and responding to other emerging technological developments or that
any development will achieve commercial acceptance. The Company is seeking and
will continue to seek to hire additional skilled development engineers. Such
engineers are likely to be in short supply, and the Company's business,
operating results and financial condition could be adversely affected if it
encounters delays in hiring or fails to retain the required skilled engineers.
See "Risk Factors -- Our success depends upon the continued contributions of our
key management,
7
marketing, product development and operational personnel. The
Company spent $1.4 million, $1.8 million and $1.8 million in research and
development activities in 2002, 2001 and 2000, respectively.
Sales, Marketing and Distribution
The Company sells its products through multiple channels, determined by
the product, market and customer need. The Company has an established two-tier
domestic and international distribution network of leading national and regional
network product distributors and resellers. Software enhancements and options
that complement the FaxPress products are primarily marketed directly by the
Company to registered end users. The direct sales group works closely with
distributors and value-added resellers ("VARs") in qualifying sales
opportunities for the fax and print server products. The Company also sells some
products through the on-line store on its Web site. Demand for the Company's
products is created through a variety of marketing programs. These programs are
targeted toward end-users to stimulate demand for the products and toward
distributors, resellers, VARs and e-commerce vendors to promote the product in
the sales channel. These programs include targeted and active participation in
industry networking and communication trade shows, as well as advertising in
associated publications. The Company increases awareness of its products by
Internet marketing via targeted e-advertising, publishing and sponsoring email
newsletters, enhancing its Web presence, print advertising, conducting direct
mail campaigns, offering seminars, trade shows and conferences, and other forms
of public relations efforts. The Company's Web site has been updated and
designed to assist customers in obtaining information about Castelle products
and contacting Castelle sales personnel, and offers selected products and
services through the Company's on-line store.
The Company's products are well suited for sale by e-commerce vendors,
and the Company has experienced success working with leading resellers such as
CDW and Insight.
In 2002, Ingram Micro and Tech Data individually accounted for more
than 10% of the Company's sales and collectively represented approximately 50%
of the Company's net sales. In 2001, the same distributors accounted for
approximately 45% of the Company's net sales. In 2000, Ingram Micro and Macnica
accounted for 31% of the Company's net sales. Sales to customers located in the
Pacific Rim and Europe comprised approximately 18%, 21% and 25% of the Company's
net sales in 2002, 2001 and 2000, respectively. In 2000, the Company terminated
its agreement with Merisel, a domestic distributor, due to the change in the
distributor's business strategy, which was not in line with the Company's
business strategy. The Company's distributors typically represent other products
that are complementary to or compete with those of the Company. While the
Company attempts to encourage its distributors to focus on its products through
a variety of marketing and support programs, distributors may give higher
priority to products of other suppliers, thereby reducing the efforts they
devote to selling our products. In particular, certain of our competitors,
including Hewlett-Packard and Intel, sell a substantially higher total dollar
volume of products through several of the Company's large U.S. distributors and,
as a result, the Company believes such distributors give higher priority to
products offered by such competitors. The Company's distributors are not
contractually committed to future purchases of the Company's products and could
discontinue carrying the Company's products at any time for any reason. The
Company has a stock rotation policy with certain of its distributors that allows
them to return marketable inventory against offsetting orders. In the event that
the Company reduces its prices, the Company credits certain of its distributors
for the difference between the purchase price of products remaining in their
inventory and the Company's reduced price for such products. See "Risk Factors -
We sell our products through a limited number of distributors, and any
deterioration in our relationship with those distributors would harm our
business, operating results and financial condition."
8
Customer Service and Support
The Company provides customers with support services, which are
available to assist customers with installation, use and operation issues that
will ensure smooth and reliable operation of Castelle products. The Company's
network engineers, located at corporate headquarters, provide technical support
via telephone, fax and email during normal Company business days from 6:00 a.m.
to 5:00 p.m. (Pacific Time). As part of the Company's global partner program,
VARs have access to "priority technical support" via a special toll-free number
that provides immediate access to Castelle network engineers. Support is
provided under warranty terms as well as through extended warranty agreements
sold directly to the customer by the Company. The Company also provides other
customer support through its Web site. The Company has an automated call
management distribution system that provides improved levels of support to help
resolve customer issues.
Manufacturing
The Company's current in-house manufacturing operations consist
primarily of material planning, assembly, final testing, quality control and
service repair. Certain of the Company's manufacturing operations are performed
by third-party manufacturers that provide customized, integrated manufacturing
services, including procurement, manufacturing and associated printed circuit
board assembly. The Company also relies on SerComm to manufacture certain of its
print server products. These arrangements enable the Company to shift certain
costs to such providers, thereby allowing the Company to focus resources on its
product development efforts. The failure of such manufacturers, particularly
SerComm, to meet their contractual commitments to the Company could cause delays
in product shipments, thereby potentially adversely affecting the Company's
business, operating results and financial condition.
The Company does not currently have any material long-term supply
contracts with any of its manufacturing subcontractors or component suppliers
other than an agreement with SerComm relating to the manufacture of print
servers. The Company purchases components on a purchase order basis. The Company
owns all engineering, sourcing documentation, functional test equipment and
tooling used in manufacturing its products, except for the products that are
produced by SerComm, and believes that it could shift product assembly to
alternate suppliers if necessary. Certain key components of the Company's
products, including a modem chip set from Conexant, and microprocessors from
Motorola, are currently available from single sources. Other components of the
Company's products are currently available from only a limited number of
sources. In addition, the Company subcontracts a substantial portion of its
manufacturing to third parties, and there can be no assurance that these
subcontractors will be able to support the manufacturing requirements of the
Company. The Company's ability to obtain these components or sub-assemblies is
dependent upon its ability to accurately forecast customer demand for its
products and to anticipate shortages of critical components or sub-assemblies
created by competing demands upon suppliers. If the Company were unable to
obtain a sufficient supply of high-quality components or sub-assemblies from its
current sources, the Company could experience delays in obtaining such
components or sub-assemblies from other sources. Resulting delays or reductions
in product shipments could adversely affect the Company's business, operating
results and financial condition and damage customer relationships. Furthermore,
a significant increase in the price of one or more of these components or
sub-assemblies or the Company's inability to lower component or sub-assembly
prices in response to competitive price reductions could adversely affect the
Company's business, operating results and financial condition. See "Risk Factors
- If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer."
9
Competition
The network enhancement products and computer software markets are
highly competitive, and the Company believes that such competition will
intensify in the future. The competition is characterized by rapid change and
improvements in technology along with constant pressure to reduce the prices of
products. The Company currently competes principally in the market for network
fax servers and network print servers and fax-on-demand software. Increased
competition, direct and indirect, could adversely affect the Company's business
and operating results through pricing pressure, loss of market share and other
factors. In particular, the Company expects that, over time, average selling
prices for its print server products will continue to decline, as the market for
these products becomes increasingly competitive. Any material reduction in the
average selling prices of the Company's products would adversely affect gross
margins. There can be no assurance the Company will be able to maintain the
current average selling prices of its products or the related gross margins.
The principal competitive factors affecting the market for the
Company's products include product functionality, performance, quality,
reliability, ease of use, quality of customer training and support, name
recognition, price, and compatibility and conformance with industry standards
and changing operating system environments. Several of the Company's existing
and potential competitors, most notably the Hewlett-Packard Company and Intel
Corporation, have substantially greater financial, engineering, manufacturing
and marketing resources than the Company. The Company also experiences
competition from a number of other software, hardware and service companies. In
addition to its current competitors, the Company may face substantial
competition from new entrants into the network enhancement market, including
established and emerging computer, computer peripheral, communications and
software companies. In the fax server market the Company competes with companies
such as Captaris Inc., Omtool, Ltd. and Computer Associates International, Inc.
There can be no assurance that competitors will not introduce products
incorporating technology more advanced than the technology used by the Company
in its products. In addition, certain competing methods of communications such
as the Internet or electronic mail could adversely affect the market for fax
products. Certain of the Company's existing and potential competitors in the
print server market are manufacturers of printers and other peripherals, and
these competitors may develop closed systems accessible only through their own
proprietary servers. There can be no assurance that the Company will be able to
compete successfully or that competition will not have a material adverse effect
on the Company's business, operating results and financial condition. See "Risk
Factors -- The markets for our products are highly competitive and may become
more competitive in the future" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Results of Operations."
Proprietary Rights
The Company's success depends to a certain extent upon its
technological expertise and proprietary software technology. The Company relies
upon a combination of contractual rights and copyright, trademark and trade
secret laws to establish and protect its technologies. Additionally, the Company
generally enters into confidentiality agreements with those employees,
distributors, customers and suppliers who have access to sensitive information
and limits access to and distribution of its software documentation and other
proprietary information. Because of the rapid pace of technological change in
the LAN product industry, the Company believes that patent protection for its
products is less significant to its success than the knowledge, ability and
experience of its employees, the frequent introduction and market acceptance of
new products and product enhancements, and the timeliness and quality of support
services provided by the Company.
Despite the precautions taken by the Company, it may be possible for
unauthorized third parties to copy certain portions of the Company's products or
to reverse engineer or obtain and use information that
10
the Company regards as proprietary. There can be no assurance that the Company's
precautions will be adequate to deter misappropriation or infringement of its
proprietary technologies. Furthermore, while the Company has obtained federal
registration for many of its trademarks in the United States, certain of its
trademarks have not been registered in the United States and the Company has
registered some of its trademarks in foreign jurisdictions. There can be no
assurance that the Company's use of such unregistered trademarks will not be
contested by third parties in the future. In addition, the laws of some foreign
countries either do not protect the Company's proprietary rights or offer only
limited protection. Given the rapid evolution of technology and uncertainties in
intellectual property law in the United States and internationally there can be
no assurance that the Company's current or future products will not be subject
to third-party claims of infringement. Any litigation to determine the validity
of any third-party claims could result in significant expense to the Company and
divert the efforts of the Company's technical and management personnel, whether
or not such litigation is determined in favor of the Company. In the event of an
adverse result in any such litigation, the Company could be required to expend
significant resources to develop non-infringing technology or to obtain licenses
to the technology that is the subject of the litigation. There can be no
assurance that the Company would be successful in such development or that any
such licenses would be available. The Company also relies on technology licenses
from third parties. There can be no assurance that these licenses will continue
to be available to the Company upon reasonable terms, if at all. Any impairment
or termination of the Company's relationship with third-party licensors could
have a material adverse effect on the Company's business, operating results and
financial condition. See "Risk Factors -- We depend on proprietary technology,
and inability to develop and protect this technology or license it from third
parties could adversely affect our business, operating results and financial
condition."
Government Regulation
Certain aspects of the networking industry in which the Company
competes are regulated both in the United States and in foreign countries.
Imposition of public carrier tariffs, taxation of telecommunications services
and the necessity of incurring substantial costs and expenditure of managerial
resources to obtain regulatory approvals, particularly in foreign countries
where telecommunications standards differ from those in the United States, or
the inability to obtain regulatory approvals within a reasonable period of time,
could have a material, adverse effect on the Company's business, operating
results and financial condition. The Company's products must comply with a
variety of equipment, interface and installation standards promulgated by
communications regulatory authorities in different countries. Changes in
government policies, regulations and interface standards could require the
redesign of products and result in product shipment delays which could have a
material, adverse impact on the Company's business, operating results and
financial condition.
Employees
As of February 28, 2003, the Company employed a total of 44 full-time
equivalent personnel, 11 in operations, 9 in sales and marketing, 7 in
engineering, 7 in customer service and 10 in finance and administration. The
Company has not experienced a work stoppage, no employees are represented by a
labor organization and the Company considers its employee relations to be good.
Executive Officers
The names of the executive officers of the Company and their ages as of
February 28, 2003 are set forth below:
11
Name Age Position
Scott C. McDonald 49 President, Chief Executive Officer
Paul Cheng 54 Vice President, Finance and Administration,
Chief Financial Officer and Secretary
Eric Chen 50 Senior Vice President, Engineering and
Product Marketing
Richard Fernandez 43 Vice President, Operations
Edward J. Heinze 57 Vice President, Sales, U.S.
Michael Petrovich 41 Vice President, Sales, International
Scott C. McDonald
Mr. McDonald joined the Company as President and Chief Executive
Officer in April 2002. Mr. McDonald has served as director of Castelle
since April 1999. From May 2001 to the first quarter of 2002, Mr. McDonald
served on the board of directors for Octant Technologies and Digital Power
Corporation and provided consulting services. Mr. McDonald served as the
Chief Financial and Administrative Officer at Conxion Corporation, a
network and Internet services company, from December 1999 to April 2001.
From 1997 to 1999, Mr. McDonald served on the board of directors for CIDCO
Inc, Octant Technologies Inc. and Digital Power Corporation; in addition to
providing consulting services to CIDCO Inc. From 1993 to 1997, Mr. McDonald
served as Executive Vice President, Chief Operating Officer, Chief
Financial Officer and Secretary at CIDCO, Inc., an innovator in advanced
telephony products. From 1989 to 1993, Mr. McDonald was Chief Financial
Officer and Vice President, Finance & Administration at Integrated Systems,
Inc., a provider of embedded operating software and design automation
tools. Prior to 1989, Mr. McDonald held financial management and operations
positions with Computer Products, Inc., Compower Corporation, Monterey
Federal Credit Union and the J.M. Smucker Company. Mr. McDonald currently
serves on the board of directors of privately held Octant Technologies,
Inc. Mr. McDonald holds a BS in Accounting from the University of Akron and
an MBA from Golden Gate University.
Paul Cheng
Mr. Cheng joined the Company in April 2000 and has served as Vice
President, Finance and Administration since that time. In March 2001, Mr.
Cheng was appointed as Chief Financial Officer and Secretary. Mr. Cheng
brings more than 20 years of financial experience from a career that was
launched in Hong Kong where he was the Plant Controller of Fairchild
Semiconductor operations. Before joining Castelle, he served as the Vice
President of Finance and Administration at Eclipse International, Inc., a
systems development company, from April 1997 to March 2000. In addition, he
has held various executive positions including the Vice President of
Finance at Quintus Corporation, a developer of customer relations
management software from 1993 to 1995 and Corporate Controller at Power
Integration, Inc., a semiconductor manufacturer from 1995 to 1997. Mr.
Cheng is a member of the Chartered Certified Accountants and holds a BS in
Accounting from Hong Kong.
Eric Chen
Mr. Chen joined the Company in 1989 and was appointed Vice President,
Engineering in May 2000. In May 2002, Mr. Chen was appointed Senior Vice
President, Engineering and Product Marketing. Mr. Chen initially worked on
software development projects including developing the first FaxPress
e-mail gateways, porting FaxPress to non-Novell platforms, and the first
menu-driven installation and configuration programs for both FaxPress and
LANpress. Most recently, Mr. Chen has been the Director of Print Server
Product Marketing and Business Unit and has managed the
12
engineering development and manufacturing business relationships with
Castelle partners. Before joining Castelle, Mr. Chen was with 3COM,
a network solutions provider. Mr. Chen has a BS in Engineering from Taiwan
and an MS in Computer Science from the University of Massachusetts.
Richard Fernandez
Mr. Fernandez joined the Company in June 2002 as Director of Operations
and was appointed Vice President of Operations in December 2002. Mr.
Fernandez has more than 22 years of manufacturing and materials planning
experience prior to joining the Company. Prior to joining Castelle, Mr.
Fernandez managed the acquisition of servers and storage devices for
Conxion Corporation from June 2000 to May 2002. Prior to joining Conxion,
Mr. Fernandez was Director of Operations with CIDCO, Inc. since March 1994.
In addition, Mr. Fernandez has held various management positions with
Computer Products Inc., MAD Intelligent Systems and Sperry Univac.
Edward J. Heinze
Mr. Heinze has been with the Company since 1994. Mr. Heinze was
appointed Vice President, Sales, U.S. in January 2000. Prior to his
appointment to Vice President, Mr. Heinze served Castelle as Product
Manager of the Fax Product Line, and Regional Sales Manager. Before joining
Castelle, Mr. Heinze served in several capacities at Visual/White Pine
Software, a software developer, including Vice President of Sales. Prior to
his tenure at White Pine, he was Chief Operations Officer for XMARK, a
computer systems manufacturer, and Vice President of Sales and Marketing at
EIT, Millicom, Olympia, and Ontel. He holds a BS degree from Waynesburg
College.
Michael Petrovich
Mr. Petrovich, Vice President, Sales, International, joined the Company
in 1992. He was appointed Vice President, International Sales in October
2000. Prior to joining the Company, Mr. Petrovich was the marketing
communications manager for Novell's National Reseller Organization, a
software company. In this role Mr. Petrovich focused on business strategies
and development of Novell's direct reseller sales channel. Before joining
Novell, Mr. Petrovich held sales and marketing positions at Excelan, a LAN
manufacturer, and International Microcircuits Incorporated, a semiconductor
company. Since joining the Company, Mr. Petrovich has concentrated on
developing the Asia Pacific marketplace and its distribution sales channel.
Most recently Mr. Petrovich has taken on the responsibilities for all sales
outside the Americas, including Asia and Europe. Mr. Petrovich holds a BA
in Behavioral Sciences from San Jose State University.
ITEM 2. PROPERTIES
The Company's headquarters, including its executive offices and
corporate administration, development, manufacturing, marketing, sales and
technical services/support facilities, are located in Morgan Hill, California in
approximately 16,600 square-feet of leased office space. The Company occupies
this facility under a lease, the term of which expires in December 2005 with one
conditional three-year option, which if exercised, would extend the lease to
December 2008. The Company also rents office space for sales and customer
support in Illinois. The Company believes its existing facilities will be
adequate to meet its requirements for the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company is involved in various legal proceedings
in the ordinary course of business. The Company is not currently involved in any
litigation which, in management's opinion,
13
would have a material adverse effect on its business, operating results, cash
flows or financial condition; however, there can be no assurance that any such
proceeding will not escalate or otherwise become material to the Company's
business in the future.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
The Company held its 2002 Annual Meeting of Shareholders on December
20, 2002 (the "2002 Annual Meeting").
At the 2002 Annual Meeting, under Proposal No. 1, the Company's
shareholders elected four directors nominated by the Board of Directors by the
votes indicated:
Nominee Votes in Favor Votes Withheld
Robert H. Hambrecht 4,250,594 86,300
Scott C. McDonald 4,240,269 96,625
Donald L. Rich 4,240,269 96,625
Peter R. Tierney 4,250,594 86,300
Proposal No. 2 to adopt the 2002 Equity Incentive Plan to provide 850,000
shares for future grants was approved with 3,311,497 votes in favor of the
proposal, 183,520 votes against and 19,999 votes abstained.
Proposal No. 3 to approve an amendment to the Company's Articles of
Incorporation to enable a reserve stock split was approved with 4,079,575 votes
in favor of the proposal, 247,320 votes against and 9,999 votes abstained.
Proposal No. 4 to ratify the selection of PricewaterhouseCoopers LLP as
the Company's independent accountants for the year ending December 31, 2002 was
approved with 4,205,766 votes in favor of the of the proposal, 2,069 votes
against and 129,059 votes abstained.
14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The Company's common stock (Nasdaq symbol "CSTL") began trading on the
Nasdaq National Market on December 20, 1995 and was transferred to the Nasdaq
SmallCap Market as of April 1999. The following table shows the closing high and
low sale prices per share of the Company's common stock as reported on the
Nasdaq SmallCap Market. Such quotations do not include retail markups, markdowns
or commissions.
2001 HIGH LOW
First Quarter $1.53 $0.88
Second Quarter $1.10 $0.75
Third Quarter $1.20 $0.56
Fourth Quarter $0.89 $0.56
2002 HIGH LOW
First Quarter $1.01 $0.64
Second Quarter $0.80 $0.57
Third Quarter $0.85 $0.50
Fourth Quarter $1.15 $0.47
As of March 13, 2003, there were 645 holders of record of the Company's
common stock. On March 13, 2003 the last sale price reported on the Nasdaq
SmallCap Market for the Company's common stock was $1.94 per share.
Stock Buyback
In the fourth quarter of 2002, the Company's Board of Directors
authorized the Company, from time to time, to repurchase at market prices, up to
$2.25 million of its common stock for cash in open market, negotiated or block
transactions. The timing of such transactions will depend on market conditions,
other corporate strategies and will be at the discretion of the management of
the Company. No time limit was set for the completion of this program. At the
time of the approval by the Board of Directors, the Company had approximately
4.8 million shares of common stock outstanding and as of the end of the third
quarter 2002, cash and cash equivalents were approximately $4.8 million. During
the fourth quarter of 2002, the Company repurchased from open market and
negotiated transactions a total of 1.62 million shares for $1.8 million,
representing an average per share price of $1.10. The Company will continue to
execute its buyback program in 2003 as it deems necessary.
Dividend Policy
The Company has not paid cash dividends on its common stock. The Board
of Directors currently intends to retain any and all earnings for use in the
Company's business and the Company does not anticipate paying cash dividends in
the foreseeable future.
15
Equity Compensation Plan Information
The following table sets forth a summary of the Company's equity
compensation plans as of December 31, 2002. Details of the plans are discussed
in Note 6 to the Consolidated Financial Statements.
Number of securities to Weighted average Number of
be issued upon exercise exercise price of securities remaining
of outstanding options, outstanding options, for future
warrants and rights warrants and rights issuance
1988 Equity compensation plan approved 11,565 $1.82 -0-
by security holders
1998 (1988) Equity compensation plan
(As Amended) approved by security 1,561,962 $0.99 -0-
holders
2002 Equity compensation plan approved 850,000 n/a 850,000
by security holders*
Equity compensation plans not approved -0- n/a -0-
by security holders
--------------------------- -------------------------- ---------------------
Total 2,423,527 $1.00 850,000
*Please note that the Company is currently in the process of applying for a
permit from the State of California to comply with state securities laws and
that no options will be granted pursuant to this plan until the permit has been
granted by the state securities authorities.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information has been derived from the
audited Consolidated Financial Statements. The information set forth below is
not necessarily indicative of results of future operations, and should be read
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and related
Notes thereto included elsewhere in this Annual Report on Form 10-K.
16
Years ended December 31,
..........................................................................
2002 2001 2000 1999 1998
-------------- ------------- -------------- ------------ ------------
(in thousands, except per share amounts)
INCOME STATEMENT DATA:
Net Sales $9,759 $9,354 $14,832 $16,116 $21,746
Gross Profit $6,923 $6,265 $9,380 $ 8,404 $11,598
Gross Profit as a % of Net Sales 71% 67% 63% 52% 53%
Net income/(loss) $659 ($591)2 $732 ($3,555)2 ($7,534)2
Net income/(loss) as a % of Net Sales 7% (6%) 5% (22%) (35%)
Net income/(loss) per share - diluted $0.14 ($0.12) $0.14 ($0.78) ($1.67)
BALANCE SHEET DATA:
Cash and Cash Equivalents $3,4601 $4,568 $3,893 $4,714 $3,924
Working Capital $2,434 $3,560 $3,969 $3,555 $6,763
Total Assets $5,635 $7,010 $8,543 $8,502 $12,494
Long-term Liabilities $44 $64 $63 -- $98
Shareholders' Equity $2,9231 $4,202 $4,776 $4,020 $7,501
(1) In 2002, cash and cash equivalents and shareholders' equity reflect
the use of $2 million of cash for the repurchase of 1.62 million shares of the
Company's common stock and the associated expenses.
(2) Net loss for 2001, 1999 and 1998 includes net charges for
restructuring and other non-recurring items of $239,000, $400,000 and $1.1
million, respectively.
Quarterly Results of Operations
The following table sets forth certain unaudited consolidated quarterly
financial data for the eight quarters ended December 31, 2002. This information
is unaudited, but in the opinion of management, has been prepared on the same
basis as the audited consolidated financial statements appearing elsewhere in
this report, and all necessary adjustments, consisting only of normal recurring
adjustments, have been included in the amounts stated below to present fairly
the unaudited interim results. The results of operations for any quarter are not
necessarily indicative of the results of operations for any future period.
Selected Quarterly Data (unaudited)
Year 2002, Quarter Ended
--------------------------------------------------------
Mar 31 Jun 30 Sep 30 Dec 31
----------------------------- --------------------------
(in thousands, except per share data)
Net sales $2,368 $2,261 $2,543 $2,587
Gross profit 1,591 1,592 1,808 1,932
Operating income 11 53 222 335
Net income 32 62 228 337
Net income per share, basic 0.01 0.01 0.05 0.09
Net income per share, diluted 0.01 0.01 0.05 0.08
17
Year 2001, Quarter Ended
--------------------------------------------------------
Mar 30 Jun 29 Sep 28 Dec 31
----------------------------- --------------------------
(in thousands, except per share data)
Net sales $2,293 $2,313 $2,500 $2,248
Gross profit 1,595 1,471 1,730 1,469
Operating (loss)/income (484) (305) 42 45
Net (loss)/income (408) (268) 53 32
Net (loss)/income per share, basic (0.09) (0.06) 0.01 0.01
Net (loss)/income per share, diluted (0.09) (0.06) 0.01 0.01
Effective January 1, 2002, Castelle redefined its quarter and year end
for financial reporting purposes to conform with calendar month ends.
This change had no significant impact on the Company's financial
position, results of operations or earnings per share.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that are subject to
many risks and uncertainties that could cause actual results to differ
significantly from expectations. For more information on forward-looking
statements, refer to the "Special Note on Forward Looking Statements" at the
front of this Annual Report on Form 10-K.
Our products have historically centered on fax and print servers and
related technologies. Starting in 1997, our revenues have declined as
competition increased, primarily with the print server products in the Asia
Pacific Region, while at the same time the Internet and other networking
technologies advanced. As a result, we experienced annual operating losses
beginning in 1997 through 1999. We redirected our efforts to focus on server
appliances and on development efforts to integrate existing and future products
with the Internet and emerging networking technologies. We introduced our new
products, the FaxPress 5000 in February 1999, FaxPress 2500 in November 1999,
FaxPress SBE in February 2000, the FaxPress 7500 in September 2000 and a major
release of our FaxPress 7.0 software in November 2002. Through mainly the
release of these enhanced products in the fax messaging family and continuous
efforts in product cost reductions, our gross profit margins improved from 53%
in 1997 to 71% in 2002.
On March 12, 2002, we received a notice from the Nasdaq Stock Market
that our common stock had failed to maintain the minimum bid price of $1.00 per
share required for continued listing on the Nasdaq SmallCap Market. On November
18, 2002, we were granted a temporary exception to Nasdaq's minimum bid price
requirement, subject to us meeting certain conditions during the term of the
exception. On December 30, 2002, our common stock bid price closed at $1.00 per
share and since then the bid price has closed above $1.00. On January 16, 2003,
we received a letter from the Nasdaq stating that we have demonstrated full
compliance with the Nasdaq Qualifications Exception issued to us on November 18,
2002.
In the fourth quarter of 2002, our Board of Directors authorized us,
from time to time, to repurchase at market prices, up to $2.25 million shares of
our common stock for cash in open market, negotiated or block transactions. The
timing of such transactions has depended and will depend on market conditions,
other corporate strategies and has been and will be at the discretion of our
management. No time limit was set for the completion of this program. As of
December 31, 2002, we
18
have repurchased from open market and negotiated transactions a total of 1.62
million shares for $1.8 million, representing an average per share price of
$1.10.
Additionally, improved cash management resulted in positive operating
cash flows in 2001 and 2002. Despite the use of $2 million of cash, including
legal and professional fees of $165,000, to repurchase our common stock in open
market and negotiated transactions following the announcement of our stock
repurchase program in October 2002, cash balances at December 31, 2002 remained
at $3.5 million, as compared to $4.6 million at the end of 2001.
Critical Accounting Policies
We have identified the policies below as critical to our business
operations and to the understanding of our results of operations. We have
defined a critical accounting policy as one that is both important to the
portrayal of our financial condition and results of operations and requires our
management to make difficult, subjective or complex judgments. The impact of any
risks associated with these policies on our business operations is discussed in
Management's Discussion and Analysis of Financial Condition and Results of
Operations. For a detailed discussion on the application of these and other
accounting policies, see Note 2 in the Notes to the Consolidated Financial
Statements in Item 15 of this Annual Report on Form 10-K, beginning on page F-6.
Note that preparation of this Annual Report on Form 10-K requires us to make
estimates and assumptions that affect the reported amount of assets and
liabilities, disclosure of contingent assets and liabilities at the date of our
financial statements, and reported amounts of revenue and expenses during the
reporting period. Estimates about future events and their effects cannot be made
with certainty. We based our estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments. These estimates may
change as new events occur, as more experience is acquired, as additional
information is obtained and as our operating environment changes.
Revenue recognition
We recognize revenue based on the provisions of Staff Accounting
Bulletin ("SAB") No. 101 "Revenue Recognition in Financial Statements" and
Statement of Financial Accounting Standards ("SFAS") No. 48 "Revenue Recognition
When Right of Return Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed and determinable, collection of the
resulting receivable is probable and product returns are reasonably estimable.
Shipment generally occurs and title is transferred when product is delivered to
a common carrier.
We enter into agreements with some of our distributors which permit
limited stock rotation rights. These stock rotation rights allow the distributor
to return products for credit but require the purchase of additional products of
equal value. Customers who purchase our products directly from us also have
limited return rights, which expire 30 days from product shipment. Revenues
subject to stock rotation rights are reduced by our estimates of anticipated
exchanges. We establish our reserve for sales returns for distributors based on
historic return rates from these distributors. If the historical data used by
the Company to calculate these estimates does not properly reflect future
returns, these estimates could be revised.
Pursuant to our agreements with distributors, we also protect our
distributors' exposure related to the impact of price reductions. Price
adjustments are recorded at the time price reductions are communicated to the
Company's distributors.
Revenue for transactions that include multiple elements such as
hardware and post-contract customer support is allocated to each element based
on its relative fair value and recognized
19
for each element when the revenue recognition criteria have been met for such
element. Fair value is generally determined based on the price charged when the
element is sold separately.
We recognize revenue from the sale of extended warranty contracts
ratably over the period of the contracts.
We recognize royalty income on the sale of LANpress products by a
Japanese distributor. Royalties are not recognized as revenue until the products
are sold by the distributor.
Distributor Programs and Incentives
We record estimated reductions to revenues for distributor programs and
incentive offerings including special pricing agreements, trade-in credits,
promotions and other volume-based incentives. If market conditions were to
change, we may take actions to increase distributor incentive offerings possibly
resulting in an incremental reduction of revenues at the time the incentive is
offered.
Warranty
Provisions for estimated warranty costs are recorded at the time
products are shipped as a charge to cost of sales. While we engage in extensive
product quality programs and processes, our warranty obligation is affected by
product failure rates, material usage and service delivery costs incurred in
correcting a product failure. Should product failure rates, material usage or
service delivery cost differ from our estimates, revision to the estimated
warranty liability would be required, which could affect the amount of gross
profit reported.
Credit, collection and allowance for doubtful accounts
We perform ongoing customer credit evaluations based on a number of
factors, including past transaction history with the customer and the
credit-worthiness of the customer. When credit criteria are not met, we require
cash-on-delivery or payment by credit card before products are shipped. On a
quarterly basis, we specifically analyze accounts receivable, potential returns,
historical bad debts, customer concentration, and changes in our customer
payment terms when evaluating the adequacy of the allowance for doubtful
accounts and for potential returns. Such returns and losses have generally been
within our expectations. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. Three customers accounted for 68% and 72%
of accounts receivable at December 31, 2002 and 2001, respectively.
Inventories and related allowance for obsolete and excess inventory
Inventories are stated at the lower of standard cost (which
approximates cost on a first-in, first-out basis) or market. Inventories are
reduced by an allowance for excess and obsolete inventories. The estimated
allowance is based on management's review of inventories on hand on a quarterly
basis, compared to management's assumptions about future demand, market
conditions and anticipated timing of the release of product upgrades or next
generation products. If actual market conditions for future demand are less
favorable than those projected by us or if product upgrades or next general
products are released earlier than anticipated, additional inventory write-downs
may be required.
Income taxes
The Company accounts for income taxes in accordance with the liability
method. Under the liability method, deferred assets and liabilities are
recognized based upon anticipated future tax consequences attributable to
differences between financial statement carrying amounts of assets and
liabilities and their respective tax bases. The provision for income taxes is
comprised of the current tax liability and the change in deferred tax assets and
liabilities. The company establishes a valuation
20
allowance to the extent that it is more likely than not that deferred tax assets
will not be recoverable against future taxable income.
Results of Operations
Comparison of Years Ended December 31, 2002 and 2001
Net Sales
Net sales consist of product sales, which are calculated net
of returns and allowances, to distributors and end-users. Sales of
products to end-users are recognized upon shipment and reduced by our
estimates of anticipated returns. Sales of products to distributors who
have limited stock rotation rights are also recognized upon shipment,
but are reduced by our estimates of anticipated exchanges and returns.
Revenue from the sale of extended warranty contracts is recognized
ratably over the period of the contracts.
Net sales increased 4% to $9.8 million in 2002 from $9.4
million in 2001. The increase of $405,000 in net sales resulted
primarily from an increase in sales of our FaxPress fax server products
of $763,000 million to the domestic channels, offset partially by a
decrease in our print server product sales of $358,000 to international
markets.
Domestic sales were $8.1 million in 2002 as compared to $7.4
million in 2001, representing 82% and 79%, respectively, of total net
sales.
International sales were $1.7 million in 2002 as compared to
$2.0 million in 2001, representing 18% and 21%, respectively, of total
net sales. Lower international sales were largely due to reduced demand
for our print server products in the Asia Pacific region. Most of our
international sales are denominated in U.S. dollars and thus could be
adversely affected by changes in demand resulting from fluctuations in
currency exchange rates.
In 2002, Ingram Micro, Tech Data and Macnica, the Company's
top three customers accounted for approximately 56% of our net sales.
In 2001, the same three distributors accounted for 55% of net sales.
Cost of Sales; Gross profit
Gross profit is equal to net sales less cost of sales. Cost of
sales includes cost of materials, including components, manuals,
diskettes, packaging materials and shipping. Cost of sales also
includes compensation costs and overhead related to the Company's
manufacturing operations, obsolescence and warranty expenses. Gross
profit was $6.9 million, or 71% of net sales, in 2002, compared to $6.3
million, or 67% of net sales, in 2001. Efficiencies realized from the
restructuring in 2001, continuous product cost reductions in 2002,
outsourcing of manufacturing and the increasingly favorable mix from
the sales of our fax server products, which have higher gross profit,
contributed to the improvement in gross profit in 2002.
Research and Development
Research and development expenses represent costs associated
with the development of new products and consist primarily of
employee-related expenses, material costs and allocated facility costs.
Research and product development expenses were $1.4 million in 2002,
compared to $1.8 million in 2001, and represented 14% and 19% of net
sales for those periods, respectively. The lower research and
development expenses in 2002 were mostly due to lower support costs of
$213,000 and reduced use of outside consulting, resulting in a savings
of $244,000. Research and
21
development spending has supported existing
products and the development of new server appliances. We remain
committed to the development of highly competitive new products and
services through the efficient utilization of our engineering
resources.
Sales and Marketing
Sales and marketing expenses consist primarily of
employee-related expenses, commissions to sales representatives,
product promotion expenses, and allocated facilities expenses,
including expenses associated with our regional sales and support
offices. Sales and marketing expenses were $3.0 million and $3.6
million for 2002 and 2001, respectively, and represented 31% and 38% of
net sales for those periods. The reduction in sales and marketing
expenses was largely due to a reduction in personnel related costs of
$395,000, which was partly realized from the restructuring in 2001 and
lower product promotional expenses of $291,000, offset in part by
higher support costs of $55,000.
General and Administrative
General and administrative expenses consist primarily of
employee-related expenses for administration, finance, human resources
and general management, as well as consulting, outside services, legal
and accounting expenses, and allocated facilities expenses. General and
administrative expenses were $1.9 million and $1.3 million for 2002 and
2001, respectively, or 20% and 14% of net sales for those periods. The
increase in expenses in 2002 was mostly due to higher legal expenses of
$128,000 and outside consulting expenses of $209,000, which were
chiefly attributable to our stock repurchase and Nasdaq listing issues.
Increased accounting fees of $81,000, compensation to board of
directors of $49,000, investor relations expenses of $72,000 and the
absence of benefit obtained from the collection of bad debts
written-off in 2001 of $115,000 also contributed to the higher general
and administrative expenses in 2002.
Restructuring Expenses
In April 2001, we terminated 17 regular, temporary and
contractor positions, which constituted approximately 25% of our
workforce. This action resulted in a restructuring charge of $239,000
in 2001. In the second quarter of 2002, a non-recurring benefit of
$40,000 arising from the reversal of previously recorded restructuring
charges was included in the results of operations, following the
completion of our 2001 restructuring program for less than previously
anticipated. The following table sets forth an analysis of the
components of the reserve balance carried-forward from 2001 (in
thousands of dollars):
Asset Write
Employee Costs Facilities Down Other Total
--------------------------------------------------------------------
Balance as of December 31, 2001 $36 $28 $ - $ 25 $ 89
Cash payments (36) - - (13) (49)
Reversal of excess accrual - (28) - (12) (40)
--------------------------------------------------------------------
Balance as of December 31, 2002 $ - $ - $ - $ - $ -
Interest and other income
Interest and other income consist primarily of interest income
earned from our invested cash balances, interest expense on capital
leases, bank service fees, and miscellaneous income and expenses.
Interest and other income was $44,000 and $111,000 in 2002 and 2001,
respectively. The decrease in other income in 2002 when compared to
2001 primarily reflected
22
lower interest income of $52,000 due to the
decline in interest rates during 2002 and miscellaneous income of
$64,000, offset in part by lower bank fees of $51,000.
Provision for Income Tax
In fiscal 2002, our provision for income taxes was $6,000,
representing state income taxes. The tax provision for federal income
taxes was offset by the utilization of our net operating loss
carryforwards.
In fiscal 2001, we incurred a loss and there were no
substantial federal nor state income taxes recognized.
Comparison of Years Ended December 31, 2001 and 2000
Net Sales
Net sales decreased 37% to $9.4 million in 2001 from $14.8
million in 2000. The decline of $5.4 million in net sales resulted
primarily from lower sales of our fax-on-demand products of $2.3
million and fax server products of $2.0, or 19%, in the domestic
channel and a decrease of our print server products of $1.2 million
mainly due to customers in the Asia Pacific Region. These declines were
in part attributable to the industry wide slowdown in the economy.
Domestic sales were $7.4 million in 2001 as compared to $11.3
million in 2000, representing 79% and 76%, respectively, of total net
sales for 2001 and 2000, respectively.
International sales were $2.0 million in 2001 as compared to
$3.6 million in 2000, representing 21% and 24%, respectively, of total
net sales. Lower international sales were largely due to reduced demand
for our print server products in the Asia Pacific region.
In 2001, three distributors accounted for approximately 55% of
our net sales. In 2000, the same three distributors accounted for
approximately 41% of net sales.
Sales in 2001 reflected a reduction of $266,000 due to the
implementation of Emerging Issues Task force No. 01-9, "Accounting for
Consideration Given by a Vendor to a Customer (Insluding a Reseller of
the Vendor's Products)" ("EITF 01-9"). However, due to the
unavailability of such data in 2000, sales in 2000 have not been
adjusted.
Cost of Sales; Gross profit
Gross profit was $6.3 million, or 67% of net sales, in 2001,
compared to $9.4 million, or 63% of net sales, in 2000. Efficiencies
realized from the restructuring in 2001, continuous product cost
reductions, outsourcing of manufacturing and the increasingly favorable
mix from the sales of our fax server products, which have higher gross
profit contribution, added to the total improvements in gross profit in
2001.
Research and Development
Research and product development expenses were $1.8 million in
2001 and 2000, and represented 19% and 12% of net sales for those
periods. Research and development spending has supported existing
products and the development of fax server appliances.
23
Sales and Marketing
Sales and marketing expenses were $3.6 million and $5.3
million for 2001 and 2000, respectively, and represented 38% and 36% of
net sales for those periods. The reduction in sales and marketing
expenses compared to 2000 was largely due to a reduction in personnel
related costs of $473,000, which was partly realized from the
restructuring, lower product promotional expenses of $406,000, reduced
outside consulting expenses of $136,000, other occupancy related costs
of $148,000 and the netting of $266,000 of expenses against sales
following the implementation of EITF 01-9.
General & Administrative
General and administrative expenses were $1.3 million and $1.7
million for 2001 and 2000, respectively, or 14% and 11% of net sales
for those periods. The decrease in expenses in 2001 was mostly due to
lower outside consulting expenses of $50,000, lower bad debt expense of
$74,000, reduced recruiting expense of $45,000 and other occupancy
related costs of $128,000.
Restructuring Expenses
In response to the continuing economic slowdown and decrease
in demand for our products, we terminated 17 regular, temporary and
contractor positions in April 2001, which constituted approximately 25%
of our workforce. This action resulted in a restructuring charge of
$239,000 in 2001. The restructuring included an asset write-off and
other direct expenses associated with the consolidation of our
operations in the United Kingdom and El Dorado Hills, California.
Of the total restructuring charge of $239,000, approximately
$124,000 represented cash charges, $26,000 represented non-cash charges
related to the write down of excess fixed assets from the consolidation
of our United Kingdom and El Dorado Hills operations, and $89,000
denoted obligations in 2002 mainly for costs associated with remaining
obligations related to our United Kingdom office and the final
severance payment to an employee. The following table sets forth an
analysis of the components of the 2001 restructuring charge, subsequent
activity, and the remaining balance as of December 31, 2001
(in thousands of dollars):
Asset Write
Employee Costs Facilities Down Other Total
--------------------------------------------------------------------
Provision for restructuring $ 98 $64 $ 26 $ 51 $ 239
Cash payments (62) (36) - (26) (124)
Non-cash items - - (26) - (26)
--------------------------------------------------------------------
Balance as of December 31, 2001 $ 36 $ 28 $ - $ 25 $ 89
Interest and other income
Interest and other income was $111,000 and $73,000 in 2001 and
2000, respectively. The increase in other income in 2001 when compared
to 2000 reflected mostly higher miscellaneous income of $58,000.
Provision for Income Taxes
In fiscal 2001, we incurred a loss and there were no
substantial federal nor state income taxes recognized.
24
In fiscal 2000, our provision for incomes taxes was $6,000,
representing state income taxes. Our federal income tax provision was
offset by the utilization of our net operating loss carryforwards.
Liquidity and Capital Resources
Since our initial public offering of common stock in December 1995, our
principal source of funding has been cash from our operations, with some funding
from capital equipment lease lines. As of December 31, 2002, we had $3.5 million
of cash and cash equivalents, a decrease of $1.1 million from December 31, 2001.
The decrease in cash and cash equivalents in 2002 was primarily attributable to
the use of $2 million, including legal and professional fees of $165,000, in the
fourth quarter of 2002 to repurchase our stock, offset partially by an
improvement in cash inflows from operating activities of $882,000.
In December 2000, as a source of capital asset financing, we entered
into a loan and security agreement with a finance company for an amount of
$75,000. This loan is subject to interest of 12.82% and is repayable by December
2006. As of December 31, 2002, the future minimum payments are $50,000.
In April 2001, as a source of capital asset financing, we entered into
a loan and security agreement with a finance company for an amount of $25,000.
This loan is subject to interest of 12.5% and is repayable by April 2003. As of
December 31, 2002, the future minimum payments are $12,000.
The Company has entered into noncancelable operating leases that expire
at various stages ending in 2006, and is responsible for certain maintenance
costs, taxes and insurance under the leases. In August 2000, the Company entered
into a lease for a new facility in Morgan Hill, California and relocated its
corporate headquarters in December 2000 after the lease at the Santa Clara,
California location expired. The lease on the new facility has a term of 5
years, expiring in December 2005 with one conditional three-year option, which
if exercised would extend the lease to December 2008 commencing with rent at
ninety-five percent of fair market value.
The following represents combined aggregate maturities for all the
Company's financing and commitments as of December 31, 2002:
Capital Lease Total Commitments
Year Ended December 31, Operating Leases Obligations
2003 $ 260 $ 28 $ 288
2004 269 20 289
2005 263 18 281
2006 - 14 14
-----------------------------------------------------------
Total Commitments $ 792 $ 80 $ 872
===========================================================
In addition to the commitments shown above, we have a $3.0 million
secured revolving line of credit with a bank, which expires in March 2004,
pursuant to which we may borrow 100% against pledges of cash at the bank's prime
rate (4.25% at December 31, 2002). Borrowings under this line of credit
agreement are collateralized by all of our assets. Under the agreement, the
Company must comply with certain financial and other covenants. As of December
31, 2002, the Company was in compliance with these covenants and there were no
borrowings outstanding under the line of credit.
25
Net cash provided by operations in 2002 was $882,000 as compared to
$643,000 in 2001. The increase was largely a result of sales increases,
improving operational efficiencies and cost reductions, offset in part by
moderate inventory increases.
Net cash used in financing activities of $2.0 million in 2002 was
largely for the repurchase of our stock and the professional fees associated
with such repurchase. We acquired additional property and equipment of $34,000,
$105,000 and $593,000 in 2002, 2001, and 2000, respectively. The spending on
property and equipment in 2001 and 2000 was largely a reflection of the
investment in leasehold improvements in our new corporate headquarters, and
excluded capital equipment of $25,000 and $75,000, respectively, purchased
through equipment leases in 2001 and 2000.
We believe that our existing cash balances, anticipated cash flows from
operations and available lines of credit will be sufficient to meet our
anticipated capital requirements for the next 12 months. If we have a need for
additional capital resources, we may be required to sell additional equity or
debt securities, secure additional lines of credit or obtain other third party
financing. The timing and amount of such capital requirements cannot be
determined at this time and will depend on a number of factors, including demand
for our existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional financing
will be available on satisfactory terms when needed, if at all. Failure to raise
such additional financing, if needed, may result in our inability to achieve our
long-term business objectives. To the extent that additional capital is raised
through the sale of additional equity or convertible debt securities, the
issuance of such securities would result in additional dilution to our
shareholders.
In addition, because of our dependency on a small number of
distributors for a significant portion of the sales of our products, the loss of
any of our major distributors or their inability to satisfy their payment
obligations to us could have a significant adverse effect on our business,
operating results and financial condition.
RISK FACTORS
Shareholders or investors considering the purchase of shares of the our
common stock should carefully consider the following risk factors, in addition
to other information in this Annual Report on Form 10-K. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial
also may impair our business operations.
Our revenue and operating results have fluctuated in the past and are likely to
fluctuate significantly in the future, particularly on a quarterly basis.
Our operating results may vary significantly from quarter to quarter
due to many factors, some of which are outside our control. For example, the
following conditions could all affect our results:
o changes in our product sales and customer mix;
o constraints in our manufacturing and assembling operations;
o shortages or increases in the prices of raw materials and components;
o changes in pricing policy by us or our competitors;
o a slowdown in the growth of the networking market;
o seasonality;
o timing of expenditures; and
o economic conditions in the United States, Europe and Asia.
Our sales often reflect orders shipped in the same quarter in which
they are received. In addition, significant portions of our expenses are
relatively fixed in nature, and planned expenditures are based
26
primarily on sales forecasts. Therefore, if the Company inaccurately forecasts
demand for our products, the impact on net income may be magnified by the
Company's inability to adjust spending quickly enough to compensate for the net
sales shortfall.
Other factors contributing to fluctuations in our quarterly operating
results include:
o changes in the demand for our products;
o customer order deferrals in anticipation of new versions of
our products;
o the introduction of new products and product enhancements by us or
our competitors;
o the effects of filling the distribution channels following
introductions of new products and product enhancements;
o potential delays in the availability of announced or anticipated
products;
o the mix of product and service revenue, the commencement or
conclusion of significant development contracts;
o changes in foreign currency exchange rates; and
o the timing of significant marketing and sales promotions.
Based on the foregoing, we believe that quarterly operating results are
likely to vary significantly in the future and that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
viewed as indications of future performance.
We have a history of losses and may not be able to sustain profitability.
We have experienced significant operating losses and, as of December
31, 2002, had an accumulated deficit of $24 million. Our development and
marketing of current and new products will continue to require substantial
expenditures. We incurred $591,000 of losses in 2001 due to a slowdown in demand
for our products due in part to an industry-wide adverse economic condition. We
were able to recover and have been profitable since the third quarter of 2001,
with a total net income of $659,000 in 2002. There can be no assurance that
growth in net sales will be achieved or profitability sustained in future years.
Our common stock is listed on the Nasdaq SmallCap Market, and we have had
difficulty satisfying the listing criteria to avoid the delisting of our common
stock
Our common stock has been listed on the Nasdaq SmallCap Market since
April 1999. In order to maintain our listing on the Nasdaq SmallCap Market, we
must maintain total assets, capital and public float at specified levels, and
our common stock generally must maintain a minimum bid price of $1.00 per share.
If we fail to maintain the standards necessary to be quoted on the Nasdaq
SmallCap Market, our common stock could become subject to delisting. There can
be no assurance that we will be able to maintain the $1.00 minimum bid price per
share of our common stock and thus maintain our listing on the Nasdaq SmallCap
Market.
If our common stock is delisted, trading in our common stock could be
conducted on the OTC Bulletin Board or in the over-the-counter market in what is
commonly referred to as the "pink sheets." If this occurs, a shareholder will
find it more difficult to dispose of our common stock or to obtain accurate
quotations as to the price of our common stock. Lack of any active trading
market would have an adverse effect on a shareholder's ability to liquidate an
investment in our common stock easily and quickly at a reasonable price. It
might also contribute to volatility in the market price of our common stock and
could adversely affect our ability to raise additional equity or debt financing
on acceptable terms or at all. Failure to obtain desired financing on acceptable
terms could adversely affect our business, financial condition and results of
operations.
27
Substantially all of our revenue comes from the sale of fax and print server
products, and a decline in demand for those products would harm our business,
operating results and financial condition.
We derive substantially all of our revenue from the sale of fax and
print server products, with fax server products accounting for 95% of total
sales in 2002. We expect that our current products will continue to account for
most of our sales in the near future. A decline in demand for our fax and print
server products as a result of competition, technological change or other
factors, or a delay in the development and market acceptance of new features and
products, would have a material adverse effect on our business, operating
results and financial condition.
We sell our products through a limited number of distributors, and any
deterioration in our relationship with those distributors would harm our
business, operating results and financial condition.
We sell our products primarily through a two-tier domestic and
international distribution network. Our distributors sell our products to VARs,
e-commerce vendors and other resellers. The distribution of personal computers
and networking products has been characterized by rapid change, including
consolidations due to the financial difficulties of distributors and the
emergence of alternative distribution channels. An increasing number of
companies are competing for access to these channels. Our distributors typically
represent other products that are complementary to, or compete with, our
products. In particular, certain of our competitors, including Hewlett-Packard
and Intel, sell a substantially higher dollar volume of products through several
of our large U.S. distributors, and as a result, we believe these distributors
give higher priority to products offered by our competitors. Our distributors
are not contractually committed to future purchases of our products and could
discontinue carrying our products at any time for any reason. In addition,
because we are dependent on a small number of distributors for a significant
portion of the sales of our products, the loss of any of our major distributors
or their inability to satisfy their payment obligations to us could have a
significant adverse effect on our business, operating results and financial
condition. We have a stock rotation policy with certain of our distributors that
allows them to return marketable inventory against offsetting orders. If we
reduce our prices, we credit certain distributors for the difference between the
purchase price of products remaining in their inventory and our reduced price
for these products. In addition, inventory levels of our products held by
distributors could become excessive due to industry conditions or the actions of
competitors, resulting in product returns and inventory write-downs.
The market for our products is affected by rapidly changing technology and if we
fail to predict and respond to customers' changing needs, our business,
operating results and financial condition may suffer.
The market for our products is affected by rapidly changing networking
technology, evolving industry standards and the emergence of the Internet and
other new communication technologies. We believe that our future success will
depend upon our ability to enhance our existing products and to identify,
develop, manufacture and introduce new products which
o conform to or support emerging network telecommunications standards;
o are compatible with a growing array of computer and peripheral devices;
o support popular computer and network operating systems and applications;
o meet a wide range of evolving user needs; and
o achieve market acceptance.
There can be no assurance that we will be successful in these efforts.
We have incurred, and expect to continue to incur, substantial expenses
associated with the introduction and promotion of new products. There can be no
assurance that the expenses incurred will not exceed research and development
cost estimates or that new products will achieve market acceptance and generate
sales sufficient to offset development costs. In order to develop new products
28
successfully, we are dependent upon timely access to information about new
technological developments and standards. There can be no assurance that we will
have such access or will be able to develop new products successfully and
respond effectively to technological change or new product announcements by
others.
We expect that printer and other peripheral manufacturers will add
features to their products that make them more network accessible, which may
reduce demand for our print servers. There can be no assurance that products or
technologies developed by others will not render our products non-competitive or
obsolete. The fax-on-demand market in general has been negatively affected by
the growth of the Internet. Although we have new Web/fax/email products in
development, there can be no assurance these products will compete successfully.
Complex products such as those offered by us may contain undetected or
unresolved hardware defects or software errors when they are first introduced or
as new versions are released. Changes in our or our suppliers' manufacturing
processes or the inadvertent use of defective components could adversely affect
our ability to achieve acceptable manufacturing yields and product reliability.
We have in the past discovered hardware defects and software errors in certain
of our new products and enhancements after their introduction. There can be no
assurance that despite testing by us and by third-party test sites, errors will
not be found in future releases of our products, which would result in adverse
product reviews and negatively affect market acceptance of these products.
The introduction of new or enhanced products requires us to manage the
transition from the older products to the new or enhanced products or versions,
both internally and for customers,. We must manage new product introductions so
as to minimize disruption in customer ordering patterns, avoid excessive levels
of older product inventories and ensure that adequate supplies of new products
can be delivered to meet customer demands. We have from time to time experienced
delays in the shipment of new products. There can be no assurance that we will
successfully manage future product transitions.
Our success depends upon the continued contributions of our key management,
marketing, product development and operational personnel.
Our success will depend, to a large extent, upon our ability to retain
and continue to attract highly skilled personnel in management, marketing,
product development and operations. Competition for employees in the computer
and electronics industries is intense, and there can be no assurance that we
will be able to attract and retain enough qualified employees. Volatility or
lack of positive performance in our stock price may also adversely affect our
ability to retain and continue to attract key employees, many of whom have been
granted stock options. Our inability to retain and attract key employees could
have a material adverse effect on our product development, business, operating
results and financial condition. We do not carry key person life insurance with
respect to any of our personnel.
The markets for our products are highly competitive and may become more
competitive in the future.
The network enhancement products and computer software markets are
highly competitive, and we believe that competition will intensify in the
future. The competition is characterized by rapid change and improvements in
technology along with constant pressure to reduce the prices of products. We
currently compete principally in the market for network fax servers and network
print servers and fax-on-demand software. Both direct and indirect competition
could adversely affect our business and operating results through pricing
pressure, loss of market share and other factors. In particular, we expect that,
over time, average selling prices for our print server products will continue to
decline, as the market for these products becomes increasingly competitive. Any
material reduction in the average selling prices of our products would adversely
affect gross margins. There can be no assurance we will be able to maintain the
current average selling prices of our products or the related gross margins.
29
The principal competitive factors affecting the market for our products
include:
o product functionality;
o performance;
o quality;
o reliability;
o ease of use;
o quality of customer training and support;
o name recognition;
o price; and
o compatibility and conformance with industry standards and
changing operating system environments.
Several of our existing and potential competitors, most notably
Hewlett-Packard and Intel, have substantially greater financial, engineering,
manufacturing and marketing resources than us. We also experience competition
from a number of other software, hardware and service companies. In addition to
our current competitors, we may face substantial competition from new entrants
into the network enhancement market, including established and emerging
computer, computer peripheral, communications and software companies. In the fax
server market we compete with companies such as Captaris Inc., Omtool, Ltd. and
Computer Associates International, Inc. There can be no assurance that
competitors will not introduce products incorporating technology more advanced
than the technology used by us in our products. In addition, certain competing
methods of communications such as the Internet or electronic mail could
adversely affect the market for fax products. Certain of our existing and
potential competitors in the print server market are manufacturers of printers
and other peripherals, and these competitors may develop closed systems
accessible only through their own proprietary servers. There can be no assurance
that we will be able to compete successfully or that competition will not have a
material adverse effect on our business, operating results and financial
condition.
We depend on sales in foreign markets, and political or economic changes in
these markets could affect our business, operating results and financial
condition.
Sales to customers located outside Canada and the United States
accounted for approximately 18%, 21% and 25% of our net sales in 2002, 2001 and
2000, respectively. We sell our products in approximately 40 foreign countries
through approximately 50 international distributors. Our principal Japanese
distributor accounted for approximately 32%, 46% and 60% of our international
sales in 2002, 2001 and 2000, respectively, and 6%, 10% and 15% of our total net
sales in 2002, 2001 and 2000, respectively. We expect that international sales
will continue to represent a significant portion of our product revenues and
that we will be subject to the normal risks of international sales, such as
export laws, currency fluctuations, longer payment cycles, greater difficulties
in accounts receivable collections and the requirement of complying with a wide
variety of foreign laws. There can be no assurance that we will not experience
difficulties resulting from changes in foreign laws relating to the export of
our products in the future. In addition, because we primarily invoice foreign
sales in U.S. dollars, fluctuations in exchange rates could affect demand for
our products by causing prices to be out of line with products priced in the
local currency. Additionally, any such difficulties would have a material
adverse effect on our international sales and a resulting material adverse
effect on our business, operating results and financial condition. In 2001, we
consolidated our operations in the United Kingdom and entered into an agreement
with a distributor to service the region. In addition, we entered into a
separate agreement in 2001 with a Japanese distributor to sell our LANpress
products in Japan, from which we are entitled to receive a royalty on sales of
these products. We may experience fluctuations in European sales on a quarterly
basis because European sales may be weaker during the third quarter than the
second quarter due to extended holiday shutdowns in July and August. There can
be no assurance that we will be able to
30
maintain the level of international sales in the future. Any fluctuations in
international sales will greatly affect our operating results and financial
condition.
The introduction of new products may reduce the demand for our existing products
and increase returns of existing products.
From time to time, we may announce new products, product versions,
capabilities or technologies that have the potential to replace or shorten the
life cycles of existing products. The release of a new product or product
version may result in the write-down of products in inventory if this inventory
becomes obsolete. We have in the past experienced increased returns of a
particular product version following the announcement of a planned release of a
new version of that product. There can be no assurance that product returns will
not exceed our allowance for these returns in the future and will not have a
material adverse effect on the our business, operating results and financial
condition.
If we fail to obtain components of our products from third-party suppliers and
subcontractors, our business could suffer.
Our products require components procured from third-party suppliers.
Some of these components are available only from a single source or from limited
sources. In addition, we subcontract a substantial portion of our manufacturing
to third parties, and there can be no assurance that these subcontractors will
be able to support our manufacturing requirements. We purchase components on a
purchase order basis, and generally have no long-term contracts for these
components. If we are unable to obtain a sufficient supply of high-quality
components from our current sources, we could experience delays or reductions in
product shipments. Furthermore, a significant increase in the price of one or
more of these components or our inability to lower component or sub-assembly
prices in response to competitive price reductions could adversely affect our
gross margin.
Government regulation could increase our costs of doing business and adversely
affect our gross margin.
Certain aspects of the networking industry in which we compete are
regulated both in the United States and in foreign countries. Imposition of
public carrier tariffs, taxation of telecommunications services and the
necessity of incurring substantial costs and expenditure of managerial resources
to obtain regulatory approvals, or the inability to obtain regulatory approvals
within a reasonable period of time, could have a material, adverse effect on our
business, operating results and financial condition. This is particularly true
in foreign countries where telecommunications standards differ from those in the
United States. Our products must comply with a variety of equipment, interface
and installation standards promulgated by communications regulatory authorities
in different countries. Changes in government policies, regulations and
interface standards could require the redesign of products and result in product
shipment delays which could have a material, adverse impact on our business,
operating results and financial condition.
We depend on proprietary technology, and inability to develop and protect this
technology or license it from third parties could adversely affect our business,
operating results and financial condition.
Our success depends to a certain extent upon our technological
expertise and proprietary software technology. We rely upon a combination of
contractual rights and copyright, trademark and trade secret laws to establish
and protect our technologies. Despite the precautions taken by us, it may be
possible for unauthorized third parties to copy our products or to reverse
engineer or obtain and use information that we regard as proprietary. In
addition, the laws of some foreign countries either do not protect our
proprietary rights or offer only limited protection. Given the rapid evolution
of technology and uncertainties in intellectual property law in the United
States and internationally, there can be no
31
assurance that our current or future products will not be subject to third-party
claims of infringement. Any litigation to determine the validity of any
third-party claims could result in significant expense and divert the efforts
our technical and management personnel, whether or not any litigation is
determined in favor of us. In the event of an adverse result in litigation, we
could be required to expend significant resources to develop non-infringing
technology or to obtain licenses to the technology that is the subject of the
litigation. There can be no assurance that the Company would be successful in
this development or that any such licenses would be available on commercially
reasonable terms. We also rely on technology licensed from third parties. There
can be no assurance that these licenses will continue to be available upon
reasonable terms, if at all. Any impairment or termination of our relationship
with third-party licensors could have a material adverse effect on our business,
operating results and financial condition. There can be no assurance that our
precautions will be adequate to deter misappropriation or infringement of our
proprietary technologies.
We have received, and may receive in the future, communications
asserting that our products infringe the proprietary rights of third parties or
seeking indemnification against the alleged infringement. There can be no
assurance that third parties will not assert infringement claims against us with
respect to current or future products or that any assertion may not require us
to enter into royalty arrangements or result in costly litigation. Any claims,
with or without merit, can be time consuming and expensive to defend. There can
be no assurance that any intellectual property litigation will not have a
material adverse effect on our business, operating results and financial
condition.
Our stock price has been volatile, and is likely to continue to be volatile in
the future.
The price of our common stock has fluctuated widely in the past. Sales
of substantial amounts of our common stock, or the perception that sales could
occur, could adversely affect prevailing market prices for our common stock. Our
management believes past fluctuations may have been caused by the factors
identified above, and that these factors may continue to affect the market price
of our common stock. Additionally, stock markets have experienced extreme price
volatility in recent years. This volatility has had a substantial effect on the
market price of the common stock of us and other high technology companies,
often for reasons unrelated to operating performance. We anticipate that prices
for our common stock may continue to be volatile. Future stock price volatility
for may result in the initiation of securities litigation against us, which may
divert substantial management and financial resources and have an adverse effect
on our business, operating results and financial condition.
We may require additional capital in the future, and may be unable to obtain
this capital at all or on commercially reasonable terms.
The development and marketing of products requires significant amounts
of capital. A decline in future orders and revenues might require us to seek
additional capital to meet our working capital needs during or beyond the next
twelve months if we are unable to reduce expenses to the degree necessary to
avoid incurring losses. If we need additional capital resources, we may be
required to sell additional equity or debt securities, secure additional lines
of credit or obtain other third party financing. The timing and amount of such
capital requirements cannot be determined at this time and will depend on a
number of factors, including demand for our existing and new products and
changes in technology in the networking industry. There can be no assurance that
additional financing will be available on satisfactory terms when needed, if at
all. Failure to raise such additional financing, if needed, may result in our
inability to achieve our long-term business objectives. To the extent that
additional capital is raised through the sale of additional equity or
convertible debt securities, the issuance of these securities would result in
additional dilution to our shareholders.
32
Recent terrorist activity in the United States and the military action to
counter terrorism could adversely impact our business.
Terrorist acts or acts of war (wherever located around the world) could
significantly impact our revenue, costs and expenses and financial condition.
The terrorist attacks that took place in the United States on September 11, 2001
have created many economic and political uncertainties, some of which may
materially harm our business, operating results and financial condition. The
long-term effects on our business of the September 11, 2001 attacks and the
ensuing war on terror are unknown. The potential for future terrorist attacks,
the national and international responses to terrorist attacks or perceived
threats to national security, and other actual or potential conflicts, acts of
war or hostility, including any action against Iraq involving the United States,
have created many economic and political uncertainties that could adversely
affect our business, operating results and financial condition in ways that
cannot presently be predicted.
The costs of compliance with recent developments in corporate governance
regulation may affect our business, operating results and financial condition in
ways that presently cannot be predicted.
Beginning with the enactment of the Sarbanes-Oxley Act of 2002, a
significant number of new corporate governance requirements have been adopted or
proposed through legislation and regulation by the Securities and Exchange
Commission and Nasdaq National Stock Market. We may not be successful in
complying with these requirements at all times in the future. Additionally, we
expect these developments to increase our legal compliance and accounting costs,
and to make some activities more difficult, such as stockholder approval of new
stock option plans. We expect these developments to make it more difficult and
more expensive for us to obtain director and officer liability insurance, and we
may be required to accept reduced coverage or incur substantially higher costs
to obtain coverage. These developments could make it more difficult for us to
attract and retain qualified members of our board of directors, or qualified
executive officers. We are presently evaluating and monitoring regulatory
developments and cannot estimate the timing or magnitude of additional costs we
may incur as a result, or the effect that these increased costs may have on our
operating results.
Voting control by officer, directors and affiliates may delay, defer or prevent
a change of control.
At March 7, 2003, our officers and directors and their affiliates
beneficially owned approximately 24% of the outstanding shares of common stock.
Accordingly, together they had the ability to significantly influence the
election of our directors and other corporate actions requiring shareholder
approval. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control.
Provisions in our charter documents might deter a company from acquiring us,
which could inhibit your ability to receive an acquisition premium for your
shares.
Our Board of Directors has authority to issue shares of preferred stock
and to fix the rights, including voting rights, of these shares without any
further vote or action by the shareholders. The rights of the holders of our
common stock will be subject to, and may be adversely affected by, the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing desirable flexibility in connection
with possible acquisitions and other corporate purposes, could have the effect
of making it more difficult for a third party to acquire a majority of our
outstanding voting stock, thereby delaying, deferring or preventing a change in
control. Furthermore, such preferred stock may have other rights, including
economic rights, senior to the common stock, and as a result, the issuance
thereof could have a material adverse effect on the market.
33
Recent Accounting Pronouncements
In July 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 146, "Accounting for
Costs Associated with Exit or Disposal Activities." SFAS No. 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan. Examples of costs covered by the standard include lease termination costs
and certain employee severance costs that are associated with a restructuring,
discontinued operation, plant closing, or other exit or disposal activity. SFAS
No. 146 replaces EITF Issue No. 94-3, " Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)". SFAS No. 146 is to be applied
prospectively to exit or disposal activities initiated after December 31, 2002.
Management does not expect this statement to have a material impact on the
Company's results of operations or consolidated financial statements, although
SFAS No. 146 may impact the timing of recognition of costs associated with
future restructuring, exit or disposal activities.
In November 2002, the FASB issued FASB Interpretation No. 45,
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, ("FIN 45"). FIN 45 requires that
upon issuance of a guarantee, a guarantor must recognize a liability for the
fair value of an obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with guarantees issued. The
recognition provisions of FIN 45 are effective for any guarantees issued or
modified after December 31, 2002. The consolidated financial statements included
in this Form 10-K comply with the disclosure requirements of this
interpretation.
In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation - Transition and Disclosure that amends SFAS No. 123,
Accounting for Stock-Based Compensation, to provide alternative methods of
transition to SFAS No. 123's fair value method of accounting for stock-based
employee compensation. SFAS No. 148 also amends the disclosure provisions of
SFAS No. 123 and APB Opinion No. 28, Interim Financial Reporting, to require
disclosure in the summary of significant accounting policies of the effects of
an entity's accounting policy with respect to stock-based employee compensation
on reported net income and earnings per share in annual and interim financial
statements. SFAS No. 148 does not amend SFAS No. 123 to require companies to
account for employee stock options using the fair value method. SFA No. 148 is
effective for fiscal years ending after December 15, 2002. The consolidated
financial statements included in this Form 10-K comply with the requirements of
SFAS No. 148.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We had no holdings of derivative financial or commodity instruments at
December 31, 2002. However, we are exposed to financial market risks, including
changes in interest rates and foreign currency exchange rates. While much of our
revenue is transacted in U.S Dollars, some revenues and capital spending are
transacted in Pounds Sterling. These amounts are not currently material to our
financial statements; therefore we believe that foreign currency exchange rates
should not materially affect our overall financial position, results of
operations or cash flows. The fair value of our money market accounts and
related income would not be significantly impacted by increases or decreases in
interest rates due mainly to the highly liquid nature of these investments.
However, sharp declines in interest rates could seriously harm interest
earnings.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements and supplementary data
required by this Item are set forth at the pages indicated in Item 15 of this
report.
34
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None
35
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Identification of Directors
The information required by this Item concerning the Company's
directors is incorporated by reference from the sections captioned "Proposal 1:
Election of Directors" contained in the Company's definitive Proxy Statement
(the "Proxy Statement"), related to its 2002 Annual Meeting of Shareholders to
be filed by the Company with the Securities and Exchange Commission ("SEC") no
later than April 30, 2003 or will be provided in an amendment to this Form 10-K
to be filed with the SEC no later than April 30, 2003.
Identification of Executive Officers
The information required by this Item concerning the Company's
executive officers is set forth in Part I of this Report.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16 of the Securities Exchange Act of 1934 requires our
directors and officers, and persons who own more than 10% of the Company's
common stock to file initial reports of ownership and reports of changes in
ownership with the Securities and Exchange Commission and the Nasdaq National
Market, and to furnish us with copies of all Section 16 forms that they file.
The Company believes that during our year ended December 31, 2002, all the
reporting persons complied with the Section 16 filing requirements.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to
the section captioned "Executive Compensation" in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference to
the section captioned "Security Ownership of Certain Beneficial Owners and
Management" contained in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In October 2002, the Company engaged W.R. Hambrecht + Co.
("WRH + Co."), an investment bank in which Mr. Hambrecht, a director of the
Company, is a partner, to manage the Company's stock buyback program approved
by the Board of Directors. As of March 10, 2003, WRH + Co. had received an
insignificant amount of compensation under this arrangement.
In January 2001, the Company had also engaged WRH + Co., to provide
certain financial advisory services to the Company. The engagement ended before
March 2001 and WRH + Co. had received an insignificant amount of compensation
under this arrangement.
36
Other information required by this Item is incorporated by reference
from the sections captioned "Certain Transactions" and "Executive Compensation"
contained in the Proxy Statement.
ITEM 14. CONTROLS AND PROCEDURES
Within the 90-day period prior to the filing of this Annual Report of
Form 10-K, an evaluation was carried out under the supervision and with the
participation of our management, including the Chief Executive Officer (the
"CEO") and Chief Financial Officer (the "CFO"), of the effectiveness of the
design and operation of our disclosure controls and procedures. Based on that
evaluation, the CEO and CFO have concluded that our disclosure controls and
procedures are effective to ensure that information required to be disclosed by
us in reports that we file or submit under the Securities Exchange Act of 1934
is recorded, processed, summarized and reported within the time periods
specified in SEC rules and forms. There were no significant changes in our
internal controls or in other factors that could significantly affect the
disclosure controls subsequent to the date of that evaluation. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within the company have been detected. These inherent limitations include
the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake. Further, the design of
a control system must reflect the fact that there are resource constraints, and
the benefits of controls must be considered relative to their costs. The design
of any system of controls is also based in part on certain assumptions regarding
the likelihood of future events, and there can be no assurance that any design
will succeed in achieving its stated goals under all potential future
conditions; over time, controls may become inadequate because of changes in
conditions, or the degree of compliance with the policies and procedures may
deteriorate.
37
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Annual Report on Form
10-K:
1) Financial Statements
Page in
Form 10-K
Report of Independent Accountants....................................... F-1
Consolidated Balance Sheets as of December 31, 2002 and 2001............ F-2
Consolidated Statements of Operations for the years ended
December 31, 2002, 2001 and 2000................................... F-3
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 2002, 2001 and 2000................................... F-4
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000................................... F-5
Notes to Consolidated Financial Statements............................. F-6
2) Financial Statement Schedules
The following financial statement schedule of Castelle for
the years ended December 31, 2002, 2001 and 2000 is filed
as part of this Form 10-K and should be read in
conjunction with the Company's Financial Statements.
Page in
Form 10-K
Schedule II - Valuation and Qualifying Accounts........................ F-23
Schedules not listed above have been omitted because they are
not applicable or are not required or because the required
information is included in the Financial Statements or Notes
thereto.
(b) Reports on Form 8-K - None
(c) Exhibits
3.1 Amended and Restated Articles of Incorporation
of the Company. (1)
3.2 Amended and Restated Bylaws of the Company. (2)
4.1 Reference is made to Exhibits 3.1 and 3.2.
10.1* 1995 Non-Employee Directors' Stock Option Plan, as
amended, and form of Director Stock Option Agreement.
10.2* Form of Indemnity Agreement between the Registrant and
each of its directors and executive officers. (1)
10.3 OEM Purchase Agreement dated May 23, 1995, by and
between the Registrant and SerComm Corporation. (1)
10.4 Distribution Agreement dated February 26, 1990, by and
between the Registrant and Ingram Micro D Inc.(1)
10.5 Distributor Contract dated June 25, 1991, as amended
June 25, 1991, by and between the Registrant and
Tech Data Corporation.(1)
38
10.7 International Distributor Agreement dated February 24,
1994, by and between the Registrant and Macnica.(1)
10.8* 1988 Equity Incentive Plan, as amended and form of
option agreements.
10.9* Form of Executive Severance and Transition Benefits
Agreement between the Company and Messier D. Rich.(3)
10.10* Employment agreement between the Company and Messier D.
Rich. (4)
10.11 International Distributor Agreement dated April 24, 2001
by and between the Registrant and AMS Limited.
10.12 Commercial Tenant Lease Agreement dated August 16, 2000
by and between the Registrant and Kyung S. Lee and
Ieesun Kim Lee.
10.13* Summary of Severance Agreements with Named Executive
Officers.
10.14 Employment agreement between the Company and Messier S.
McDonald
10.15 Form of Executive Severance and Transition Benefits
Agreement between the Company and Messier S. McDonald
10.16 2002 Equity Incentive Plan
10.17 Loan and Security Agreement with Silicon Valley Bank
10.18 Loan Modification Agreement with Silicon Valley Bank
11.1 Computation of Net Income (Loss) Per Share. Reference
is made to page F-9 of the Notes to Consolidated
Financial Statements.
23.1 Consent of PricewaterhouseCoopers LLP.
------------------
(1)Previously filed as an exhibit to the Company's Registration Statement
on Form SB-2 (Reg. No. 33-99628-LA-) or amendments thereto and
incorporated herein by reference.
(2) Previously filed with the Company's Form 10-K for the year ended
December 31, 2000.
(3)Previously filed as an exhibit to the Company's Form 10-K for the year
ended December 31, 1999 and incorporated herein by reference.
(4) Previously filed as an exhibit to the Company's Form 10-K for the year
ended December 31, 1998 and incorporated herein by reference.
* Indicates management contracts or compensatory plans or arrangements
filed pursuant to Item 601(b)(10) of Regulation S-K.
39
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Act of 1934, an amended, the Registrant has duly caused this Annual Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly
authorized on the twenty-eighth day of March 2003.
By: /S/ SCOTT C. MCDONALD
-----------------------------------------------
Scott C. McDonald
Chief Executive Officer and President
KNOW BY ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Scott C. McDonald, as his true and lawful
attorney-in-fact and agent, with full power of substitution for him, and in his
name in any and all capacities, to sign any and all amendments to this Annual
Report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorney-in-fact and agent, full power and authority to do
and perform each and every act and thing requisite and necessary to be done
therewith, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorney-in-fact and
agent, and any of them, or his substitute or substitutes, may lawfully do or
cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Annual Report on Form 10-K has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated:
Name Title Date
/S/ SCOTT C. MCDONALD Chief Executive Officer, President
--------------------- (principal executive officer), Director March 28, 2003
Scott C. McDonald
/S/ PAUL CHENG Vice President,
-------------- Finance and Administration, March 28, 2003
Paul Cheng Chief Financial Officer (principal
accounting officer), Secretary
/S/ DONALD L. RICH Chairman of the Board and Director March 28, 2003
------------------
Donald L. Rich
/S/ ROBERT HAMBRECHT Director March 28, 2003
--------------------
Robert Hambrecht
/S/ PETER TIERNEY Director March 28, 2003
-----------------
Peter Tierney
40
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, SCOTT C. MCDONALD, certify that:
1. I have reviewed this annual report on Form 10-K of Castelle;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this annual report (the "Evaluation Date");
and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 28, 2003 By: /s/ SCOTT C. MCDONALD
Scott C. McDonald
President and Chief Executive Officer
CERTIFICATION PURSUANT TO
SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002
I, PAUL CHENG, certify that:
1. I have reviewed this annual report on Form 10-K of Castelle;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this annual report (the "Evaluation Date");
and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 28, 2003 By: /s/ PAUL CHENG
Paul Cheng
Chief Financial Officer
Castelle
Consolidated Financial Statements
as of December 31, 2002 and 2001
and for each of the three years in the
period ended December 31, 2002
Report of Independent Accountants
To the Board of Directors and
Shareholders of Castelle
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15 (a)(1) on page 38 present fairly, in all material
respects, the financial position of Castelle and its subsidiaries at December
31, 2002 and 2001, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2002 in conformity with
accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 15(a)(2) on page 38 presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Jose, California
February 12, 2003
Castelle
Consolidated Balance Sheets
(in thousands)
--------------------------------------------------------------------------------
December 31,
------------------------------------
2002 2001
---------------- -----------------
Assets
Current assets:
Cash and cash equivalents $ 3,460 $ 4,568
Accounts receivable, net of allowance for doubtful accounts
of $70 in 2002 and $96 in 2001 444 680
Inventories 1,110 926
Prepaid expenses and other current assets 88 130
---------------- -----------------
Total current assets 5,102 6,304
Property and equipment, net 425 598
Other assets 108 108
---------------- -----------------
Total assets $ 5,635 $ 7,010
================ =================
Liabilities and Shareholders' Equity
Current liabilities:
Long-term debt, current portion $ 21 $ 18
Accounts payable 359 280
Accrued liabilities 2,288 2,446
---------------- -----------------
Total current liabilities 2,668 2,744
Long-term debt, net of current portion 44 64
---------------- -----------------
Total liabilities 2,712 2,808
---------------- -----------------
Commitments and contingencies (Note 4)
Shareholders' Equity:
Preferred stock, no par value:
Authorized: 2,000 shares in 2002 and 2001
Issued and outstanding: none in 2002 and 2001 - -
Common stock, no par value:
Authorized: 25,000 shares
Issued and outstanding: 3,187 shares in 2002
and 4,745 shares in 2001 27,038 28,977
Deferred compensation - (1)
Accumulated deficit (24,115) (24,774)
---------------- -----------------
Total shareholders' equity 2,923 4,202
---------------- -----------------
Total liabilities and shareholders' equity $ 5,635 $ 7,010
================ =================
F-2
The accompanying notes are an integral part of these financial statements
Castelle
Consolidated Statements of Operations
(in thousands, except per share data)
--------------------------------------------------------------------------------
Year Ended December 31
--------------------------------------------------------
2002 2001 2000
----------------- ----------------- -----------------
Net sales $ 9,759 $ 9,354 $ 14,832
Cost of sales 2,836 3,089 5,452
----------------- ----------------- -----------------
Gross profit 6,923 6,265 9,380
----------------- ----------------- -----------------
Operating expenses:
Research and development 1,383 1,805 1,759
Sales and marketing 3,016 3,588 5,293
General and administrative 1,943 1,335 1,663
Restructuring charge/(recovery) (40) 239 -
----------------- ----------------- -----------------
6,302 6,967 8,715
----------------- ----------------- -----------------
Operating income/(loss) 621 (702) 665
Interest income, net 43 94 195
Other income/(expense), net 1 17 (122)
----------------- ----------------- -----------------
Income/(loss) before provision for
income taxes 665 (591) 738
Provision for income taxes 6 - 6
----------------- ----------------- -----------------
Net income/(loss) $ 659 $ (591) $ 732
================= ================= =================
Net income/(loss) per common share - basic $ 0.15 $ (0.12) $ 0.16
================= ================= =================
Net income/(loss) per common share - diluted $ 0.14 $ (0.12) $ 0.14
================= ================= =================
Shares used in per share calculation - basic 4,539 4,744 4,664
================= ================= =================
Shares used in per share calculation - diluted 4,586 4,744 5,080
================= ================= =================
F-3
The accompanying notes are an integral part of these financial statements.
Castelle
Consolidated Statements of Shareholders' Equity
Years Ended December 31, 2002, 2001 and 2000
(in thousands)
--------------------------------------------------------------------------------
Common Stock
-------------------------- Deferred Accumulated
Shares Amount Compensation Deficit Total
------------ ------------ ------------- ------------ ------------
Balances, December 31, 1999 4,641 $ 29,002 $ (67) $ (24,915) $ 4,020
Issuance of common stock through
exercise of stock options 30 24 - - 24
Exchange of warrants
for common stock 70 - - - -
Deferred compensation related to options issued to - 17 (17) - -
consultant
Write-off of deferred compensation
related to options issued to consultant - (67) 67 - -
Net income - - - 732 732
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2000 4,741 28,976 (17) (24,183) 4,776
============ ============ ============= ============ ============
Issuance of common stock through
exercise of stock options 4 1 - - 1
Deferred compensation related to options issued to - 4 (4) - -
consultant
Revaluation of options issued to consultants - (4) 4 - -
Amortization of deferred compensation - - 16 - 16
Net loss - - - (591) (591)
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2001 4,745 28,977 (1) (24,774) 4,202
============ ============ ============= ============ ============
Issuance of common stock through
exercise of stock options 61 38 - - 38
Repurchase and cancellation of common stock (1,619) (1,977) - (1,977)
Amortization of deferred compensation - - 1 - 1
Net Income - - - 659 659
------------ ------------ ------------- ------------ ------------
Balances, December 31, 2002 3,187 $ 27,038 $ - $ (24,115) $ 2,923
============ ============ ============= ============ ============
F-4
The accompanying notes are an integral part of thesefinancial statements.
Castelle
Consolidated Statements of Cash Flows
Years Ended December 31, 2002, 2001 and 2000
(in thousands)
--------------------------------------------------------------------------------
Year Ended December 31,
....................................................
2002 2001 2000
---------------- ---------------- ----------------
Cash flows from operating activities:
Net income/(loss) $ 659 $ (591) $ 732
Adjustments to reconcile net income/(loss) to
net cash provided by (used in) operating activities:
Depreciation and amortization 206 230 260
Provision for doubtful accounts and sales returns (21) 59 (257)
Provision for excess and obsolete inventory (105) 148 (80)
Compensation expense related to grant of stock options 1 16 -
Loss/(profit) on disposal of fixed assets 1 44 (10)
Changes in assets and liabilities:
Accounts receivable 257 1,344 (301)
Inventories (79) 289 128
Prepaid expenses and other current assets 42 79 53
Other assets - (6) (24)
Accounts payable 79 (734) (322)
Accrued liabilities (158) (235) (367)
---------------- ---------------- ----------------
Net cash provided by/(used in) operating activities 882 643 (188)
---------------- ---------------- ----------------
Cash flows from investing activities:
Acquisition of property and equipment (34) (105) (593)
Proceeds from sale of fixed assets - - 34
---------------- ---------------- ----------------
Net cash used in investing activities (34) (105) (559)
---------------- ---------------- ----------------
Cash flows from financing activities:
Return of restricted cash - 125 -
Issuance/(Repayment) of notes payable (17) 11 (98)
Repurchase of common stock (1,977) - -
Proceeds from issuance of common stock, net of repurchases 38 1 24
---------------- ---------------- ----------------
Net cash provided by/(used in) financing activities (1,956) 137 (74)
---------------- ---------------- ----------------
Net (decrease)/increase in cash and cash equivalents (1,108) 675 (821)
Cash and cash equivalents, beginning of period 3,893 4,714
4,568
---------------- ---------------- ----------------
Cash and cash equivalents, end of period $ 3,460 $ 4,568 $ 3,893
================ ================ ================
Supplemental information:
Cash paid during the period for:
Interest $ 10 $ 12 $ 6
Income taxes $ - $ - $ 5
Noncash investing and financing activities:
Note payable for fixed asset acquisition $ - $ 25 $ 75
F-5
The accompanying notes are an integral part of these financial statements
Castelle
Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------
1. Business and Organization of the Company
Castelle develops, manufactures, markets and supports office automation
systems that allow organizations to easily implement faxing and printing
over local area networks and the Internet. Castelle's FaxPress fax
servers provide a simple way to integrate fax with email, desktop and
back-end applications. The Company also provides LANpress print servers,
which enable users to locate printers anywhere on the network, and the
InfoPress information-on-demand software suite..
The Company distributes its products primarily through a two-tier,
domestic and international distribution network, with its distributors
selling Castelle's products to value-added resellers, system integrators,
e-commerce retailers and other resellers in the United States, Europe and
the Pacific Rim. The Company also has relationships with selected
original equipment manufacturers and sells software enhancements and
upgrades directly to end-users.
The Company believes that its existing cash balances, anticipated cash
flows from operations and available lines of credit will be sufficient to
meet its anticipated capital requirements for the next 12 months. If the
Company has a need for additional capital resources, the Company may be
required to sell additional equity or debt securities, secure additional
lines of credit or obtain other third party financing. The timing and
amount of such capital requirements cannot be determined at this time and
will depend on a number of factors, including demand for the Company's
existing and new products, if any, and changes in technology in the
networking industry. There can be no assurance that such additional
financing will be available on satisfactory terms when needed, if at all.
Failure to raise such additional financing, if needed, may result in the
Company not being able to achieve its long-term business objectives. To
the extent that additional capital is raised through the sale of
additional equity or convertible debt securities, the issuance of such
securities would result in additional dilution to the Company's
shareholders.
In addition, because the Company is dependent on a small number of
distributors for a significant portion of the sales of its products, the
loss of any of the Company's major distributors or their inability to
satisfy their payment obligations to the Company could have a significant
adverse effect on the Company's business, operating results and financial
condition. The Company's three largest distributors accounted for 56%,
55% and 41% of the Company's sales in 2002, 2001 and 2000, respectively.
2. Summary of Significant Accounting Policies
Use of estimates in preparation of financial statements
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
F-6
Principles of consolidation
The consolidated financial statements include the accounts of Castelle
and its wholly owned subsidiaries in the United States and the United
Kingdom. All intercompany balances and transactions have been eliminated.
Fiscal year
Effective January 1, 2002, Castelle redefined its quarter and year end
for financial reporting purposes to conform with calendar month ends,
i.e., ending on March 31, June 30, September 30 and December 31.
Previously, Castelle set its quarter as ending on the Friday of the
thirteenth week into the quarter. This change had no significant impact
on the Company's financial position, results of operations or cash flows
for the 2002 periods presented herein.
Financial instruments
Cash equivalents consist of highly liquid investments with original
maturities of three months or less when purchased.
For financial instruments consisting of cash and cash equivalents,
accounts receivable, accounts payable and accrued liabilities included in
the Company's financial statements, the carrying amounts approximate fair
value due to their short maturities.
Concentrations of credit risk
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of trade receivables,
cash equivalents, short-term marketable securities and long-term
marketable securities. With respect to trade receivables, the Company
performs ongoing credit evaluations of its customers' financial
condition. Additionally, the Company establishes an allowance for
doubtful accounts based upon factors surrounding the credit risk of
specific customers, historical trends and other available information.
Three customers accounted for 68%, 72% and 59% of accounts receivable at
December 31, 2002, 2001 and 2000, respectively. Although the Company does
not require collateral on certain accounts receivable on sales to large,
well-established companies, it does require prepayments on certain sales
to foreign and smaller companies.
With respect to cash equivalents, short-term marketable securities and
long-term marketable securities, the Company has cash investment policies
that limit the amount of credit exposure to any one issuer and restrict
placement of these investments to issuers evaluated as creditworthy.
Inventories and related allowance for obsolete and excess inventory
Inventories are stated at the lower of standard cost (which approximates
cost on a first-in, first-out basis) or market. Inventories have also
been reduced by an allowance for excess and obsolete inventories. The
estimated allowance is based on management's review of inventories on
hand, compared to management's assumptions about future demand, market
conditions and anticipated timing of the release of product upgrades or
next generation products. If actual market conditions for future demand
are less favorable than those projected by us or if product upgrades or
next generation products are released earlier than anticipated,
additional inventory write-downs may be required.
F-7
Property and equipment
Property and equipment are stated at cost less accumulated depreciation
and amortization. Depreciation is provided using the straight-line method
over the estimated useful lives of the respective assets, generally three
to seven years. Amortization of leasehold improvements is provided on a
straight-line basis over the life of the related asset or the lease term,
if shorter. Gains and losses upon asset disposal are recognized in the
year of disposition. Expenditures for replacements and betterments are
capitalized, while expenditures for maintenance and repairs are charged
against earnings as incurred.
Accounting for long-lived assets
The Company reviews long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability is measured by comparison of its
carrying amount to future net cash flows the assets are expected to
generate. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of
the asset exceeds its fair market value.
Revenue recognition
The Company recognizes revenue based on the provisions of Staff
Accounting Bulletin ("SAB") No. 101 "Revenue Recognition in Financial
Statements" and Statement of Financial Accounting Standards ("SFAS") No.
48 "Revenue Recognition When Right of Return Exists."
Product revenue is recognized upon shipment if a signed contract or
purchase order exists, the fee is fixed and determinable, collection of
the resulting receivables is probable and product returns are reasonably
estimable. Shipment generally occurs and title is transferred when
product is delivered to a common carrier.
The Company enters into agreements with some of its distributors which
permit limited stock rotation rights. These stock rotation rights allow
the distributor to return products for credit but require the distributor
to purchase additional products of equal value. Customers who purchase
products directly from Castelle also have limited return rights, which
expire 30 days from the date of product shipment. Revenues subject to
stock rotation rights are reduced by management's estimates of
anticipated exchanges. Castelle establishes its reserve for sales returns
for distributors and direct customers based on historic return rates.
Pursuant to the Company's distributor agreements, the Company also
protects its distributors' exposure related to the impact of price
reductions. Price adjustments are recorded at the time price reductions
are communicated to the Company's distributors.
Revenue for transactions that include multiple elements such as hardware
and post-contract customer support is allocated to each element based on
its relative fair value and recognized for each element when the revenue
recognition criteria have been met for such element. Fair value is
generally determined based on the price charged when the element is sold
separately.
The Company recognizes revenue from support or maintenance contracts,
including extended warranty and support programs, ratably over the period
of the contract.
Castelle recognizes royalty income on the sale of LANpress products by a
Japanese distributor. Royalties are not recognized as revenue until the
products are sold by the distributor.
F-8
Provisions for estimated warranty costs are recorded as a component of
cost of sales at the time products are shipped.
Shipping and handling
Costs related to shipping and handling are included in cost of sales for
all periods presented.
Advertising costs
Advertising costs, included in sales and marketing expenses, are expensed
as incurred and were $193,000, $446,000 and $1,171,000 in 2002, 2001 and
2000, respectively. Advertising costs in 2000 were not reduced by the
impact of the implementation of Emerging Issues Task force No. 01-9,
"Accounting for Consideration Given by a Vendor to a Customer (Including
a Reseller of the Vendor's Products)" ("EITF 01-9"), as such data were
not available.
Research and development expenses
Costs related to the conceptual formulation and design of both hardware
and software products are expensed as research and development while
costs incurred subsequent to establishing technological feasibility of
software products are capitalized until general release of the product.
Generally, technological feasibility is established upon completion of a
working model. No significant costs subsequent to such point have been
incurred, and all such costs have been expensed.
Income taxes
The Company accounts for income taxes in accordance with the liability
method. Under the liability method, deferred assets and liabilities are
recognized based upon anticipated future tax consequences attributable to
differences between financial statement carrying amounts of assets and
liabilities and their respective tax bases. The provision for income taxes
is comprised of the current tax liability and the change in deferred tax
assets and liabilities. The company establishes a valuation allowance to
the extent that it is more likely than not that deferred tax assets will
not be recoverable against future taxable income.
Foreign currency translation
The functional currency of the Company's foreign subsidiaries are the
U.S. dollar. Accordingly, all assets and liabilities are translated into
U.S. dollars at the current exchange rates as of the applicable balance
sheet date. Revenues and expenses are translated at the average exchange
rates prevailing during the period. Cumulative gains and losses from the
translation of the foreign subsidiaries' financial statements have not
been material to date. Foreign exchange gains and losses resulting from
foreign currency transactions were not material in any of the periods
presented.
Net income/(loss) per share
Basic net income/(loss) per share is computed by dividing net
income/(loss) available to common shareholders by the weighted average
number of common shares outstanding for that period. Diluted net
income/(loss) per share is computed giving effect to all dilutive
potential common shares that were outstanding during the period. Dilutive
potential shares consist of incremental common shares issuable upon
exercise of stock options and warrants.
F-9
Basic and diluted earnings per share are calculated as follows for 2002,
2001 and 2000 (in thousands except per share amounts):
2002 2001 2000
--------------- ---------------- ----------------
Basic:
Weighted average shares 4,539 4,744 4,664
=============== ================ ================
Net income/(loss) $ 659 $ (591) $ 732
=============== ================ ================
Net income/(loss) per share $ 0.15 $ (0.12) $ 0.16
=============== ================ ================
Diluted:
Weighted average shares 4,539 4,744 4,664
Common equivalent shares from stock options 47 - 416
--------------- ---------------- ----------------
Shares used in per share calculation 4,586 4,744 5,080
=============== ================ ================
Net income/(loss) $ 659 $ (591) $ 732
=============== ================ ================
Net income/(loss) per share $ 0.14 $ (0.12) $ 0.14
=============== ================ ================
Due to the losses in the period, the calculation of diluted shares
outstanding for 2001 excludes 901,000 shares of common stock subject to
outstanding stock options, as their effect was antidilutive in the
period. In 2002 and 2000, no shares of common stock were excluded.
Stock-Based Compensation
On December 31, 2002, the FASB issued SFAS No. 148, "Accounting for Stock
Based Compensation - Transition and Disclosure," which amends SFAS No.
123. SFAS No. 148 requires more prominent and frequent disclosures about
the effects of stock-based compensation, which the Company has adopted
for the year ended December 31, 2002. The Company accounts for its
stock-based compensation plans using the intrinsic value method
prescribed in Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees." Compensation cost for stock options, if any,
is measured by the excess of the quoted market price of the Company's
stock at the date of grant over the amount an employee must pay to
acquire the stock. SFAS No. 123, "Accounting for Stock-Based
Compensation," established accounting and disclosure requirements using a
fair-value based method of accounting for stock-based employee
compensation plans.
F-10
Had compensation costs been determined consistent with SFAS No. 123, the
Company's net income or loss would have been changed to the amounts
indicated below for the years ended December 31 (in thousands, except per
share data):
2002 2001 2000
--------------- -------------- -------------
Net income/(loss) - as reported $ 659 $ (591) $ 732
Fair value of stock-based compensation (176) (65) (143)
--------------- -------------- -------------
Net income/(loss) - pro forma $ 483 $ (656) $ 589
=============== ============== =============
Net income/(loss) per share - basic - as reported $ 0.15 $ (0.12) $ 0.16
Net income/(loss) per share - diluted - as reported $ 0.14 $ (0.12) $ 0.14
Net income/(loss) per share - basic - pro forma $ 0.11 $ (0.14) $ 0.13
Net income/(loss) per share - diluted - pro forma $ 0.11 $ (0.14) $ 0.12
Stock-based compensation included in net income/(loss), as
reported $ 1 $ 16 $ -
The Company accounts for stock-based compensation arrangements with
non-employees in accordance with the Emerging Issues Task Force ("EITF")
Abstract No. 96-18, Accounting for Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling Goods
or Services. Accordingly, unvested options and warrants held by
non-employees are subject to revaluation at each balance sheet date based
on the then current fair market value.
Comprehensive income
Comprehensive income is the change in equity from transactions and other
events and circumstances other than those resulting from investments by
owners and distributions to owners. There are no significant components
of comprehensive income excluded from net income, and therefore, no
separate statement of comprehensive income has been presented.
Segment information
The Company uses one measurement of profitability of its business for
internal purposes and has determined that it operates in one business
segment: server appliances. The Company's sales by geographic area are
included in Note 9.
Recent accounting pronouncements
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 requires
companies to recognize costs associated with exit or disposal activities
when they are incurred rather than at the date of a commitment to an exit
or disposal plan. Examples of costs covered by the standard include lease
termination costs and certain employee severance costs that are
associated with a restructuring, discontinued operation, plant closing,
or other exit or disposal activity. SFAS No. 146 replaces EITF Issue No.
94-3, " Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity (including Certain Costs Incurred in
a Restructuring)". SFAS No. 146 is to be applied prospectively to exit or
disposal activities initiated after December 31, 2002. Management does
not expect this statement to have a material impact on the Company's
results of operations or
F-11
consolidated financial statements, although SFAS
No. 146 may impact the timing of recognition of costs associated with
future restructuring, exit or disposal activities.
In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, ("FIN 45"). FIN 45 requires that
upon issuance of a guarantee, a guarantor must recognize a liability for
the fair value of an obligation assumed under a guarantee. FIN 45 also
requires additional disclosures by a guarantor in its interim an annual
financial statements about the obligations associated with guarantees
issued. The recognition provisions of FIN 45 are effective for any
guarantees issued or modified after December 31, 2002. These consolidated
financial statements comply with the disclosure requirements of this
interpretation.
In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation - Transition and Disclosure that amends SFAS No.
123, Accounting for Stock-Based Compensation, to provide alternative
methods of transition to SFAS No. 123's fair value method of accounting
for stock-based employee compensation. SFAS No. 148 also amends the
disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim
Financial Reporting, to require disclosure in the summary of significant
accounting policies of the effects of an entity's accounting policy with
respect to stock-based employee compensation on reported net income and
earnings per share in annual and interim financial statements. SFAS No.
148 does not amend SFAS No. 123 to require companies to account for
employee stock options using the fair value method. SFA No. 148 is
effective for fiscal years ending after December 15, 2002. These
consolidated financial statements comply with the requirements of SFAS
No. 148.
3. Balance Sheet Detail (in thousands)
Inventories:
December 31,
----------------------------------
2002 2001
---------------- ----------------
Raw material $ 493 $ 283
Work in process 179 182
Finished goods 438 461
---------------- ----------------
Total inventories $ 1,110 $ 926
================ ================
F-12
Property and equipment:
December 31,
----------------------------------
2002 2001
---------------- ----------------
Production, test and demonstration equipment $ 353 $ 350
Computer equipment 1,112 1,102
Office equipment 82 82
Leasehold improvements 436 436
---------------- ----------------
1,983 1,970
Less accumulated depreciation and amortization (1,558) (1,372)
---------------- ----------------
Total property and equipment $ 425 $ 598
================ ================
As of December 31, 2002 and 2001, the Company had $100,000 of
equipment under capital leases. Accumulated depreciation and
amortization associated with these capital leases was $42,000 and
$19,000 at December 31, 2002 and 2001, respectively. The Company
recorded depreciation and amortization related to property and
equipment of $206,000, $230,000 and $260,000 in 2002, 2001 and
2000, respectively.
Accrued liabilities:
December 31,
..................................
2002 2001
---------------- ----------------
Accrued compensation $ 351 $ 733
Accrued sales and marketing 377 331
Accrued professional fees 490 430
Deferred revenue 592 444
Other accruals 478 508
---------------- ----------------
Total accrued liabilities $ 2,288 $ 2,446
================ ================
4. Commitments and Contingencies
Lease Commitments
The Company has entered into noncancelable operating leases that expire
at various dates ending in 2006, and is responsible for certain
maintenance costs, taxes and insurance under the leases. The lease on the
Company's headquarters facility has a term of 5 years, expiring in
December 2005 with one conditional three-year option, which if exercised
would extend the lease to December 2008 commencing with rent at
ninety-five percent of fair market value. Future minimum payments under
noncancelable operating leases are as follows (in thousands):
F-13
Year Ended December 31,
2003 $ 280
2004 285
2005 278
2006 14
----------------
$ 857
================
Rent expense, including the facility lease and equipment rental, was
$298,000, $360,000, and $510,000 for 2002, 2001 and 2000, respectively.
The Company leases certain of its equipment under various operating and
capital leases that expire at various dates through 2006. The lease
agreements frequently include renewal and escalation clauses and purchase
provisions and require the Company to pay taxes, insurance and
maintenance costs. As of December 31, 2002, the Company had loan and
security agreements for an aggregate value of $100,000, which are subject
to interest rates of 12.5% to 12.8%. As of December 31, 2002, future
minimum lease payments are as follows (in thousands):
Year Ended December 31,
2003 $ 28
2004 20
2005 17
2006 15
----------------
Total minimum lease payments 80
Less amount representing interest (15)
----------------
Present value of capital lease obligations 65
Less current portion (21)
----------------
Long-term portion of capital lease obligations $ 44
================
Product Warranties and Guarantor Arrangements
In November 2002, the FASB issued FIN No. 45 "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, an interpretation of FASB Statements No. 5, 57,
and 107 and rescission of FASB Interpretation No. 34 ("FIN 45"). FIN 45
requires that a guarantor recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken by issuing the
guarantee. FIN 45 also requires additional disclosures to be made by a
guarantor in its interim and annual financial statements about its
obligations under certain guarantees it has issued.
The Company offers warranties on certain products and records a liability
for the estimated future costs associated with warranty claims, which is
based upon historical experience and the Company's estimate of the level
of future costs. Warranty costs are reflected in the income statement as
a cost of sales. A reconciliation of the changes in the Company's
warranty liability for the year ending December 31, 2002 follows (in
thousands):
F-14
Warranty accrual at the beginning of the year $ 22
Accruals for warranties issued during the year 38
Settlements made in kind during the year (26)
----------------
Warranty accrual at the end of the year $ 34
================
As permitted under California law the Company has agreements whereby the
Company indemnifies its officers and directors for certain events or
occurrences while the officer or director is, or was serving, at the
Company's request in such capacity. The term of the indemnification
period is for the officer's or director's lifetime. The maximum potential
amount of future payments the Company could be required to make under
these indemnification agreements is unlimited; however, the Company has a
director and officer insurance policy that limits the Company's exposure
and enables the Company to recover a portion of any future amounts paid.
As a result of the Company's insurance policy coverage, the Company
believes the estimated fair value of these indemnification agreements is
minimal.
The Company enters into standard indemnification agreements in the
ordinary course of business. Pursuant to these agreements, the Company
indemnifies, holds harmless, and agrees to reimburse the indemnified
party for losses suffered or incurred by the indemnified party, generally
the Company's business partners or customers, in connection with any U.S.
patent, or any copyright or other intellectual property infringement
claim by any third party with respect to the Company's services. The term
of these indemnification agreements is generally perpetual following
execution of the agreement. The maximum potential amount of future
payments the Company could be required to make under these
indemnification agreements is unlimited; however, the Company has never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, the Company believes the
estimated fair value of these agreements is minimal.
5. Bank Borrowings
The Company has a $3.0 million collateralized revolving line of credit
with a bank, which expires in March 2004, pursuant to which the Company
may borrow 100% against pledges of cash at the bank's prime rate (4.25%
at December 31, 2002). Borrowings under this line of credit agreement are
collateralized by all of the assets of the Company. Under the agreement,
the Company must comply with certain financial and other covenants. As of
December 31, 2002, the Company was in compliance with these covenants and
there were no borrowings outstanding under the line of credit
6. Common Stock
2002 Equity Incentive Plan
In December 2002, the shareholders of the Company approved the adoption
of the 2002 Equity Incentive Plan ("2002 Plan"). A total of 850,000
shares of common stock have been reserved for issuance under the 2002
Plan. The 2002 Plan provides for awards to employees, directors,
consultants and independent advisors. The adoption of the 2002 Plan was
necessitated by the use or expiration of all but an insignificant amount
of authorized shares under the prior option plans, (the 1995 Non-employee
Directors' Stock Option Plan ("Directors Plan") and the 1988 Incentive
F-15
Stock Plan ("1988 Plan")). Under the 2002 Plan, the Board of Directors
may grant either the right to purchase shares or options to purchase
shares of the Company's common stock at prices not less than the fair
market value at the date of grant for incentive stock options and 85% of
the fair market value at the date of grant for non-qualified options and
purchase rights. Options granted under the 2002 Plan generally become
exercisable, and the Company's right to repurchase shares issued and sold
pursuant to stock purchase rights generally lapses, at a rate of
one-quarter of the shares under option or purchased under stock purchase
rights at the end of the first year and thereafter ratably over the next
three years. Awards under the 2002 Plan generally expire seven years from
the date of grant. No additional option grants will be made under any
prior option plan. As of December 31, 2002, no options have been granted
under the 2002 Plan.
The following table summarizes option activity under the Company's stock
option plans (in thousands):
Outstanding Options
Weighted
Average
Available Number Exercise
for Grant Outstanding Price
------------------ ------------------ ------------------
Balances, January 1, 2000 304 1,451 $1.17
Options granted (286) 286 $1.22
Options cancelled 352 (394) $1.44
Options exercised - (30) $0.77
------------------ ------------------ ------------------
Balances, December 31, 2000 370 1,313 $1.11
Options granted (156) 156 $0.79
Options cancelled 61 (61) $1.11
Options exercised - (4) $0.20
------------------ ------------------ ------------------
Balances, December 31, 2001 275 1,404 $1.08
Options granted (405) 405 $0.71
Options cancelled 151 (175) $1.08
Options expired (21) -
Options exercised - (61) $0.63
------------------ ------------------ ------------------
Balances, December 31, 2002 - 1,573 $1.00
================== ================== ==================
At December 31, 2002, 2001 and 2000, 1,087,000, 1,035,000 and 779,000
options, respectively, were exercisable at a weighted average exercise
price of $1.10, $1.12 and $1.11, respectively.
F-16
Options to purchase common stock outstanding and currently exercisable by
exercise price at December 31, 2002, are as follows (in thousands, except
years and per share data):
Options Outstanding Options Exercisable
.................................................................... .................................
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
----------------- ---------------- ---------------- ---------------- ---------------- ----------------
$0.00-$0.50 10 6.3 $0.34 10 $0.34
$0.56-$0.75 410 6.1 $0.69 63 $0.67
$0.76-$1.00 734 3.8 $0.93 644 $0.94
$1.01-$1.25 115 5.3 $1.12 84 $1.11
$1.26-$1.50 72 3.9 $1.32 54 $1.34
$1.51-$1.75 194 1.7 $1.57 194 $1.57
$1.76-$2.00 31 7.1 $1.94 31 $1.94
$2.01-$3.00 7 5.2 $2.37 7 $2.37
---------------- ----------------
1,573 4.3 $1.00 1,087 $1.10
================ ================
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes model with the following assumptions for 2002,
2001 and 2000:
2002 2001 2000
------------------- ------------------- -----------------
Risk-free interest rate 3.86%-5.43% 4.22%-5.25% 5.85%-6.44%
Expected life 6.9 years 7.0 years 6.71 years
Expected dividends - - -
Volatility 146% 355% 163%
The weighted average fair value of options granted in 2002, 2001 and 2000
was $0.71, $0.67 and $1.21 per share, respectively.
Option Grants to Non-employees
In addition to the options granted under the plans detailed above,
Castelle has granted options to purchase common stock to consultants
under special arrangements.
During the years ended December 31, 2001 and 2000, the Company granted
3,000 and 20,000 options, respectively, to non-employees.. Under EITF
96-18, the unvested options are revalued at each balance sheet date to
reflect their current fair value. Compensation expense is reflected in
results of operations over the vesting period. As of December 31, 2002,
the following assumptions were used in determining the fair value of the
options: dividend yield of 0%, expected volatility of 180%, risk-free
interest rate of 5.48% and a contractual life of 3 years, resulting in a
deemed fair market value per share of $0.75.
F-17
In connection with its grant of options to non-employees, the Company
recorded charges of $1,000 and $16,000 in 2002 and 2001, respectively.
Options to purchase 33,000, 35,000 and 55,000 shares of common stock were
held by non-employees at December 31, 2002, 2001 and 2000, respectively,
of which 33,000, 35,000 and 35,000 were exercisable for aggregate total
exercise proceeds of $50,000, $52,000 and $52,000, respectively.
7. Income Taxes
The Company recorded a provision for income taxes of $6,000 in each of
2002 and 2000. No provision for income taxes was made in 2001 as the
Company incurred a loss.
The Company's tax provision differs from the provision computed using
statutory income tax rates as follows (in thousands):
2002 2001 2000
---------------- -------------- --------------
Federal tax provision/(benefit) at statutory rate $ 248 $ (201) $ 210
Permanent difference due to
non-deductible expenses 7 8 36
State taxes provision/(benefit), net of federal benefit 6 (7) 4
Utilization of Net Operating Loss Carryovers (122) - (66)
Change in valuation allowance (65) 258) (124)
General business credits (68) (58) (54)
---------------- -------------- --------------
$ 6 $ - $ 6
================ ============== ==============
The components of the net deferred tax assets are as follows (in
thousands):
December 31,
...................................
2002 2001
---------------- -----------------
Inventory allowances and adjustments $ 131 $ 211
Accounts receivable allowances 28 38
Other liabilities and allowances 567 558
Net operating loss carryforwards 4,727 4,929
Tax credit carryforwards 1,825 1,950
Depreciation and amortization 411 260
Valuation allowance (7,689) (7946)
---------------- -----------------
Total net deferred tax assets $ - $ -
================ =================
Based on the available objective evidence, management believes it is more
likely than not that the net deferred tax assets will not be fully
realizable. Accordingly, the Company has provided a full valuation
allowance against its net deferred tax assets at December 31, 2002 and
2001.
F-18
At December 31, 2002, the Company had net operating loss carryforwards of
approximately $13,334,000 and $3,323,000 available to offset future
federal and California taxable income, respectively. These loss
carryforwards will expire in varying amounts beginning in 2004 through
2022. In addition, at December 31, 2002, the Company had Federal and
California Research and Development credit carryforwards of approximately
$1,175,000 and $776,000, respectively. These credits expire in varying
amounts beginning in 2007.
For federal and state income tax purposes, the amount of benefit from a
portion of the Company's net operating loss carryforwards may be impaired
or limited if the Company incurs a cumulative ownership change of more
than 50%, as defined, over a three year period.
The Company's profit (loss) before provision for income taxes for all
periods presented was derived substantially from domestic operations.
8. Retirement Plan
The Company has a voluntary 401(k) plan covering substantially all
employees. The plan provides for employer contributions at the discretion
of the Board of Directors. In 2002, 2001 and 2000, the Company made no
contributions to the plan.
9. Major Customers and Segment Information
Revenues by geographic area are determined by the location of the
customer and are summarized as follows (in thousands):
Years Ended December 31,
...................................................
2002 2001 2000
---------------- ---------------- ---------------
North America $ 8,046 $ 7,368 $ 11,260
Europe 826 960 853
Pacific Rim 887 1,026 2,719
---------------- ---------------- ---------------
Total revenues $ 9,759 $ 9,354 $ 14,832
================ ================ ===============
Customers that individually accounted for greater than 10% of net sales
are as follows (in thousands):
Years Ended December 31,
..............................................................................................
2002 2001 2000
Customer Amount Percentage Amount Percentage Amount Percentage
----------------- -------------- --------------- --------------- --------------- --------------- -------------
A $ 2,657 26% $ 2,591 28% $ 2,485 17%
B 2,257 22% 1,635 18% 1,463 10%
C * * 915 10% 2,183 15%
* - In 2002, this customer was responsible for less than 10% of net sales
F-19
10. Restructuring
In response to the continuing economic slowdown and decrease in demand
for the Company's products, the Company terminated 17 regular, temporary
and contractor positions in April 2001, which constituted approximately
25% of the Company's workforce. The restructuring included an asset
write-off and other direct expenses associated with the consolidation of
our operations in the United Kingdom and El Dorado Hills, California.
In the second quarter of 2002, a non-recurring benefit of $40,000 arising
from the reversal of a portion of the previously recorded restructuring
charge was included in the results of operations, following the
completion of the Company's 2001 restructuring program for less than
previously anticipated. The following table sets forth an analysis of the
components of the restructuring charge, and subsequent activity
(in thousands):
Employee Asset Write
Costs Facilities Down Other Total
Provision for restructuring $ 98 $64 $ 26 $ 51 $ 239
Non-cash items - - (26) - (26)
Cash payments (62) (36) - (26) (124)
--------------------------------------------------------------------
Balance as of December 31, 2001 36 28 - 25 89
Cash payments (36) - - (13) (49)
Reversal of excess accrual - (28) - (12) (40)
--------------------------------------------------------------------
Balance as of December 31, 2002 $ - $ - $ - $ - $ -
11. Litigation
From time to time, the Company is involved in various legal proceedings
in the ordinary course of business. The Company is not currently involved
in any litigation, which, in management's opinion, would have a material
adverse effect on its business, operating results, cash flows or
financial condition; however, there can be no assurance that any such
proceeding will not escalate or otherwise become material to the
Company's business in the future.
12. Stock Buyback
In the fourth quarter of 2002, the Company's Board of Directors
authorized the Company, from time to time, to repurchase at market
prices, up to $2.25 million of its common stock for cash in open market,
negotiated or block transactions. The timing of such transactions will
depend on market conditions, other corporate strategies and will be at
the discretion of the management of the Company. No time limit was set
for the completion of this program. At the time of the approval by the
Board of Directors, the Company had approximately 4.8 million shares of
common stock outstanding and as of the end of the third quarter 2002,
cash and cash equivalents were approximately $4.8 million. During the
fourth quarter of 2002, the Company repurchased through open market and
negotiated transactions a total of 1.62 million shares for $1.8 million,
representing an average per share price of $1.10.
F-20
Castelle Schedule II
Valuation and Qualifying Accounts
(in thousands)
--------------------------------------------------------------------------------
Additions
Balance at Charged to Balance at
Beginning Costs and End of
of Period Expenses Deductions Period
---------------- ---------------- ---------------- ----------------
Year Ended December 31, 2000:
Deducted from asset accounts:
Allowance for doubtful accounts $ 263 $ 257 $ 345 $ 175
Provision for excess and obsolete inventory $ 459 $ 80 $ 173 $ 366
Year Ended December 31, 2001:
Deducted from asset accounts:
Allowance for doubtful accounts $ 175 $ 59 $ 138 $ 96
Provision for excess and obsolete inventory $ 366 $ 148 $ (4) $ 518
Year Ended December 31, 2002:
Deducted from asset accounts:
Allowance for doubtful accounts $ 96 $ (21) $ 5 $ 70
Provision for excess and obsolete inventory $ 518 $ - $ 202 $ 316
F-21
Castelle
Index to Exhibits
--------------------------------------------------------------------------------
Exhibit
Number Description
------ ----------------------------------------------------------------
10.14 Employment agreement between the Company and Messier S. McDonald
10.15 Form of Executive Severance and Transition Benefits Agreement
between the Company and Messier S. McDonald
10.16 2002 Equity Incentive Plan
10.17 Loan and Security Agreement with Silicon Valley Bank
10.18 Loan Modification Agreement with Silicon Valley Bank
23.1 Consent of Independent Accountants
F-22